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– Dr Ann Butchers, Senior Teaching Fellow, University of Warwick, UK
This popular text takes a practical approach to corporate finance, applying key concepts and techniques to a broad range of
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CORPORATE FINANCE
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“A book that meets the needs of students at many levels using straightforward clear explanations. Written in
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Richard Pike & Bill Neale
fifth edition
CORPORATE FINANCE
AND INVESTMENT
DECISIONS & STRATEGIES
• Increased emphasis given to international aspects by drawing
together relevant material into a new Part VI on International Finance;
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Bill Neale is Associate Reader in Financial Management at the University of Bournemouth Institute of Business & Law. He is
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why I have long used this book as the required text for my corporate finance course.”
Pike & Neale
Richard Pike is a Chartered Accountant and Professor of Accounting and Finance at the Bradford University School of
Management.
fifth
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CORPORATE FINANCE AND INVESTMENT
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CORPORATE FINANCE
AND INVESTMENT
DECISIONS & STRATEGIES
Fifth Edition
Richard Pike and Bill Neale
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Pearson Education Limited
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First published 1993
Fifth edition published 2006
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To our wives, Carol and Jean
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Contents
List of figures and tables
Preface
Guided tour of the book
Guided tour of the companion website
Acknowledgements
Publisher’s acknowledgements
xiii
xvi
xx
xxii
xxiii
xxiv
Part I
A FRAMEWORK FOR FINANCIAL
DECISIONS
Chapter 1
An overview of financial management
1.1
1.2
1.3
1.4
1.5
1.6
1.7
1.8
1.9
1.10
1.11
1.12
1.13
Introduction
The finance function
Investment and financial decisions
Cash – the lifeblood of the business
The emergence of financial management
The finance department in the firm
The financial objective
The agency problem
Managing the agency problem
Social responsibility and shareholder wealth
The corporate governance debate
The risk dimension
The strategic dimension
Summary
Key points
Further reading
Questions
3
4
5
6
7
8
9
10
11
12
13
14
16
17
20
20
21
22
Chapter 2
The financial environment
24
2.1
2.2
2.3
2.4
2.5
2.6
2.7
2.8
25
25
27
30
34
41
43
44
Introduction
Financial markets
The financial services sector
The London Stock Exchange (LSE)
Are financial markets efficient?
A modern perspective – chaos theory
Short-termism in the City
Reading the financial pages
2.9
Taxation and financial decisions
46
Summary
Key points
Further reading
Appendix: Financial statement analysis
Questions
47
47
47
48
57
Chapter 3
Present values and financial arithmetic
60
3.1
3.2
3.3
3.4
3.5
3.6
3.7
3.8
Introduction
Measuring wealth
Time-value of money
Financial arithmetic for capital growth
Present value
Present value arithmetic
Valuing bonds
Net present value
61
61
62
63
65
68
71
73
Summary
Key points
Further reading
Appendix I: The term structure of interest rates
and the yield curve
Appendix II: The investment–consumption decision
Appendix III: Present value formulae
Questions
77
77
77
Chapter 4
Valuation of assets, shares
and companies
4.1
4.2
4.3
4.4
4.5
4.6
4.7
4.8
4.9
4.10
4.11
4.12
Introduction
The valuation problem
Valuation using published accounts
Valuing the earnings stream: P:E ratios
EBITDA – a halfway house
Valuing cash flows
The DCF approach
Valuation of unquoted companies
Valuing shares: the Dividend Valuation Model
Problems with the Dividend Growth Model
Shareholder value analysis
Economic Value Added (EVA)
78
79
84
86
88
89
89
90
96
98
98
100
103
104
106
109
111
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viii Contents
Summary
Key points
Further reading
Questions
112
113
113
114
INVESTMENT DECISIONS
AND STRATEGIES
Chapter 5
Investment appraisal methods
121
5.1
5.2
5.3
5.4
5.5
5.6
5.7
5.8
5.9
122
122
123
125
127
128
129
130
134
Summary
Key points
Further reading
Appendix I: Modified IRR
Appendix II: Multi-period capital rationing
and mathematical programming
Questions
137
137
138
138
139
144
Chapter 6
Project appraisal – applications
147
6.1
6.2
6.3
6.4
6.5
6.6
6.7
148
148
151
153
155
157
159
Introduction
Incremental cash flow analysis
Replacement decisions
Inflation cannot be ignored
Taxation is a cash flow
Use of DCF techniques
Traditional appraisal methods
Summary
Key points
Further reading
Appendix: The problem of unequal lives: Allis plc
Questions
163
163
164
164
166
Chapter 7
Investment strategy and process
173
7.1
7.2
174
174
Introduction
Strategic considerations
7.4
7.5
7.6
Advanced manufacturing technology
(AMT) investment
Environmental aspects of investment
The capital investment process
Post-auditing
Summary
Key points
Further reading
Questions
Part II
Introduction
Cash flow analysis
Investment techniques – net present value
Internal rate of return
Profitability index
Payback period
Accounting rate of return
Ranking mutually exclusive projects
Investment evaluation and capital rationing
7.3
178
180
181
188
190
190
190
191
Part III
INVESTMENT RISK AND RETURN
Chapter 8
Analysing investment risk
8.1
8.2
195
Introduction
Expected net present value (ENPV):
Betterway plc
Attitudes to risk
The many types of risk
Measurement of risk
Risk description techniques
Adjusting the NPV formula for risk
Risk analysis in practice
197
197
198
200
204
208
210
Summary
Key points
Further reading
Appendix: Multi-period cash flows and risk
Questions
211
211
212
212
215
Chapter 9
Relationships between investments:
portfolio theory
219
8.3
8.4
8.5
8.6
8.7
8.8
9.1
9.2
9.3
9.4
9.5
9.6
9.7
9.8
Introduction
Portfolio analysis: the basic principles
How to measure portfolio risk
Portfolio analysis where risk and return
differ
Different degrees of correlation
Worked example: Gerrybild plc
Portfolios with more than two components
Can we use this for project appraisal?
Some reservations
Summary
Key points
Further reading
Questions
196
220
221
223
226
227
228
231
233
234
234
234
235
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Contents
Chapter 10
Setting the risk premium: the Capital Asset
237
Pricing Model
10.1
10.2
10.3
10.4
Introduction
Security valuation and discount rates
Concepts of risk and return
The relationship between different equity
markets
10.5 Systematic risk
10.6 Completing the model
10.7 Using the CAPM: assessing the
required return
10.8 The underpinnings of the CAPM
10.9 Portfolios with many components:
the capital market line
10.10 How it all fits together: the key
relationships
10.11 Reservations about the CAPM
10.12 Testing the CAPM
10.13 Factor models
10.14 The Arbitrage Pricing Theory
10.15 Issues raised by the CAPM: some food
for managerial thought
238
238
239
243
244
249
250
254
255
257
259
260
261
262
263
Summary
Key points
Further reading
Appendix: Analysis of variance
Questions
266
266
266
267
269
Chapter 11
The required rate of return on
investment and Shareholder
Value Analysis
271
11.1 Introduction
11.2 The required return in all-equity firms:
the DGM
11.3 The required return in all-equity firms:
the CAPM
11.4 Using value drivers – Shareholder Value
Analysis (SVA)
11.5 Worked example: Safa plc
11.6 Using ‘tailored’ discount rates
11.7 Another problem: taxation and the CAPM
11.8 Problems with ‘tailored’ discount rates
11.9 A critique of divisional hurdle rates
Summary
Key points
Further reading
Questions
272
272
276
278
280
283
288
289
290
291
291
292
293
Chapter 12
Identifying and valuing options
12.1
12.2
12.3
12.4
Introduction
Share options
Option pricing
Application of option theory to
corporate finance
12.5 Capital investment options
12.6 Why conventional NPV may not tell the
whole story
Summary
Key points
Further reading
Appendix: Black–Scholes option pricing formula
Questions
ix
296
297
297
304
309
311
314
315
315
316
316
318
Part IV
SHORT-TERM FINANCING
AND POLICIES
Chapter 13
Treasury management and working
capital policy
323
13.1 Introduction
13.2 The treasury function
13.3 Funding
13.4 How firms can use the yield curve
13.5 Banking relationships
13.6 Risk management
13.7 Working capital management
13.8 Predicting corporate failure
13.9 Cash operating cycle
13.10 Working capital policy
13.11 Overtrading problems
324
324
326
328
329
330
337
339
340
342
346
Summary
Key points
Further reading and website
Questions
348
348
348
349
Chapter 14
Short-term asset management
353
14.1
14.2
14.3
14.4
14.5
14.6
354
354
361
362
367
370
Introduction
Managing trade credit
Worked example: Pickles Ltd
Inventory management
Cash management
Worked example: Mangle Ltd
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14.7 Cash management models
372
Summary
Key points
Further reading
Appendix: Miller–Orr cash management model
Questions
373
373
374
374
376
Chapter 15
Short- and medium-term finance
379
15.1
15.2
15.3
15.4
15.5
Introduction
Trade credit
Bank credit facilities
Invoice finance
Using the money market:
bill finance
15.6 Hire purchase (HP)
15.7 Leasing
15.8 Lease evaluation: a simple case
15.9 Motives for leasing
15.10 Allowing for Corporation Tax in lease
evaluation
15.11 Financing international trade
380
380
382
385
Summary
Key points
Further reading
Questions
405
405
406
407
387
389
391
393
396
398
402
Part V
STRATEGIC FINANCIAL DECISIONS
Chapter 16
Long-term finance
16.1 Introduction
16.2 Guiding lights: corporate aims and
corporate finance
16.3 How companies raise finance
in practice
16.4 Shareholders’ funds
16.5 Methods of raising equity finance
16.6 Debt instruments: debentures, bonds
and notes
16.7 Leasing and sale-and-leaseback (SAL)
Summary
Key points
Further reading
Questions
411
412
412
413
414
417
432
441
443
443
443
444
Chapter 17
Returning value to shareholders:
the dividend decision
17.1
17.2
17.3
17.4
17.5
17.6
447
Introduction
The strategic dimension
The legal dimension
The theory: dividend policy and firm value
Objections to dividend irrelevance
The information content of dividends:
dividend smoothing
17.7 Alternatives to cash dividends
17.8 The dividend puzzle
17.9 Conclusions
448
449
450
450
458
Summary
Key points
Further reading
Appendix: Home-made dividends
Questions
472
472
473
473
475
Chapter 18
Capital structure and the required
return
478
18.1
18.2
18.3
18.4
18.5
463
465
470
471
Introduction
Measures of gearing
Operating and financial gearing
Financial gearing and risk: Lindley plc
The ‘traditional’ view of gearing and
the required return
18.6 The cost of debt
18.7 The overall cost of capital
18.8 Worked example: Damstar plc
18.9 More on Economic Value Added (EVA)
18.10 Financial distress
18.11 Two more issues: signalling and
agency costs
18.12 Conclusions
479
480
484
486
504
504
Summary
Key points
Further reading
Appendix: Slipping down the credit ratings
Questions
506
506
506
507
508
Chapter 19
Does capital structure really matter?
512
19.1 Introduction
19.2 The Modigliani–Miller message
19.3 MM’s propositions
513
513
515
489
492
494
496
498
499
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Contents
19.4 Does it work? Impediments to arbitrage
19.5 MM with corporate income tax
19.6 Capital structure theory and the CAPM
19.7 Linking the Betas
19.8 MM with financial distress
19.9 Calculating the WACC
19.10 The adjusted present value method (APV)
19.11 Which discount rate should we use?
519
519
522
525
526
527
530
532
Summary
Key points
Further reading
Appendix I: Derivation of MM’s Proposition II
Appendix II: MM’s Proposition III: the cut-off
rate for new investment
Appendix III: Allowing for personal taxation:
Miller’s revision
Questions
533
533
534
534
Chapter 20
Acquisitions and restructuring
20.1
20.2
20.3
20.4
20.5
535
536
537
541
Introduction
Takeover waves
Motives for takeover
Financing a bid
Evaluating a bid: the expected gains
from takeovers
20.6 Worked example: ML plc and CO plc
20.7 The importance of strategy
20.8 The strategic approach
20.9 Post-merger activities
20.10 Assessing the impact of mergers
20.11 Value gaps
20.12 Other forms of value-creating
542
542
548
552
554
555
557
558
563
567
573
575
Summary
Key points
Further reading
Questions
582
582
582
584
21.3 Foreign exchange exposure
21.4 Should firms worry about exchange
rate changes?
21.5 Economic theory and exposure management
21.6 Exchange rate forecasting
21.7 Devising a Foreign Exchange Management
(FEM) strategy
21.8 Internal hedging techniques
21.9 External hedging techniques
21.10 Conclusions
xi
598
600
601
607
610
614
617
623
Summary
Key points
Further reading
Questions
624
624
625
626
Chapter 22
Foreign investment decisions
630
22.1
22.2
22.3
22.4
22.5
22.6
Introduction
Advantages of MNCS over national firms
Foreign market entry strategies
The incremental hypothesis
Complexities of foreign investment
The discount rate for Foreign Direct
Investment (FDI)
22.7 Evaluating FDI
22.8 Exposure to foreign exchange risk
22.9 How MNCs manage operating
exposure
22.10 Hedging the risk of foreign projects
22.11 Political and country risk
22.12 Managing Political and country risk (PCR)
22.13 Financing FDI
22.14 The WACC for FDI
22.15 Applying the APV to FDI
631
631
632
634
636
645
646
647
650
651
653
654
Summary
Key points
Further reading
Questions
656
656
656
658
Chapter 23
Review and behavioural finance
661
637
638
642
Part VI
INTERNATIONAL FINANCE
Chapter 21
Managing currency risk
21.1 Introduction
21.2 The structure of exchange rates: spot
and forward rates
593
594
596
23.1
23.2
23.3
23.4
Introduction
Review of main principles in finance
Behavioural finance
The changing finance function – if we had
20/20 vision!
662
662
665
670
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xii Contents
Summary
Key points
Further reading
671
672
672
Appendices
A Solutions to self-assessment
673
activities
B Solutions to selected questions
C Present value interest factor (PVIF)
D Present value interest factor for an annuity
(PVIFA)
691
722
Glossary
References
Index
726
735
743
Supporting resources
Visit www.pearsoned.co.uk/pikeneale to find valuable online resources:
Companion Website for students
Summary of each chapter to aid revision
■ Self-assessment questions to check your understanding
■ Annotated links to relevant sites on the Internet
■ An online glossary to explain key terms
■ Quests per chapter to improve information seeking skills.
■
For instructors
■ Complete, downloadable Instructor’s Manual including summary of question material and answers to all questions not answered in the book itself
■ Extra question and answer material for use in class or for examinations
■ Case studies for more in-depth discussion on practical issues
■ PowerPoint lecture slides that can be downloaded and used as OHTs.
Also: the Companion Website provides the following features:
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724
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List of figures and tables
List of figures
1.1
1.2
1.3
1.4
1.5
2.1
The finance function in a large organisation
6
Cash–the lifeblood of the business
7
The risk–return trade-off
16
Main elements in strategic planning
17
Factors influencing the value of the firm
18
Financial markets, institutions, suppliers
and users
26
2.2 Chart showing breakout beyond
resistance line
36
3.1 The relationship between present value
of £1 and interest over time
68
3.2 Investment appraisal elements
73
3.3 The term structure of interest rates
78
3.4 Investment opportunities for Platt Enterprises 81
3.5 Investment and financing opportunities
for Platt Enterprises
82
3.6 Investment decisions in imperfect capital
markets
84
4.1 Calculating free cash flow (FCF)
102
4.2 Shareholder value analysis framework
109
5.1 Lara proposal: NPV–IRR graph
127
5.2 NPV and IRR compared
133
7.1 McKinsey–GE portfolio matrix
175
7.2 Normal progression of product over time
176
7.3 Investment strategy
177
7.4 A simple capital budgeting system
183
8.1 Risk profiles
198
8.2 Risk-averse investor’s utility function
198
8.3 Variability of project returns
201
8.4 Mean–variance analysis
203
8.5 Sensitivity graph
204
8.6 Simulated probability distributions
207
8.7 How risk is assumed to increase over time 209
9.1 Equal and offsetting fluctuations in returns 220
9.2 Available portfolio risk-return
combinations when assets, risks and
expected returns are different
227
9.3 The effect on the efficiency frontier of
changing correlation
228
9.4 Gerrybild’s opportunity set
231
9.5 Portfolio combinations with three assets
232
10.1 Total Shareholder Return (TSR)
240
10.2 Specific vs. market risk of a portfolio
10.3 The effect of international diversification
on portfolio risk
10.4 Combining the Warsaw and the
London markets
10.5 The characteristics line: no specific risk
10.6 The characteristics line: with
specific risk
10.7 The security market line
10.8 The capital market line
10.9 The CAPM: the three key relationships
10.10 Theoretical and empirical SMLs
10.11 Alternative characteristics lines
11.1 Risk premiums for activities of
varying risk
11.2 The Beta pyramid
12.1 Payoff lines for share options in Enigma
Drugs plc
12.2 BP call option
12.3 BP put option
12.4 Option and share price movements for
Bradford plc
12.5 The value of the options to delay
investments: Cardiff Components Ltd
13.1 Financing working capital: the matching
approach
13.2 Financing working capital needs: an
aggressive strategy
13.3 Yield curves
13.4 Cash conversion cycle
13.5 Helsinki plc working capital strategies
13.6 Optimal level of working capital for a
‘relaxed’ strategy
13.7 Optimal level of working capital for an
‘aggressive’ strategy
14.1 The credit management process
14.2 Ordering and debt collection cycle
14.3 The inventory cycle
14.4 Cash flow activity for main stakeholders
14.5 Miller-Orr cash management model
15.1 How hire purchase works
16.1 How an SPV works
241
243
244
245
246
249
256
258
260
267
283
284
298
302
303
306
312
327
328
329
341
343
345
345
355
359
364
368
375
390
434
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xiv List of figures and tables
17.1
17.2
18.1
18.2
19.1
19.2
19.3
19.4
20.1
20.2
21.1
The impact of a permanent dividend cut
Dividends as a residual
How gearing affects the ROE
The ‘traditional’ view of capital structure
MM’s Propositions I and II
The MM thesis with corporate income tax
Business and financial risk premia and the
required return
Optimal gearing with liquidation costs
A strategic framework
Type of acquisition and integrative
complexity
Sterling exchange rates, 1999–2004
453
456
488
491
517
521
524
527
559
564
595
21.2 Interlocking theories in international
economics
21.3 Flow chart demonstrating a logical
approach towards devising a foreign
exchange management strategy
21.4 Illustration of multiple netting
21.5 Achieving the swap
22.1 Alternative modes of market entry
22.2 Exporting vs. FDI
22.3 Classification of firms by extent of
operating exposure
22.5 A simple APV model
A.1 Portfolio combinations with four assests
606
611
614
623
633
635
642
655
680
List of tables
2.1
Share price information for the food
retail sector
2.2 Foto-U plc
2.3 Foto-U key ratios
2.4 Foto-U annual corporate performance report
3.1 Compound interest on £1,000 over five
years (at 10%)
3.2 Annual percentage rates for a loan with
interest payable at 22 per cent per annum
3.3 Present value of a single future sum
4.1 Balance sheet for DS Smith plc as at
30 April 2004
4.2 Football clubs quoted on the London Stock
Exchange
4.3 How earnings and dividends grow in
tandem (figures in £m)
4.4 Calculation of EVA
5.1 Net present value calculations
5.2 Why NPV makes sense to shareholders
5.3 IRR calculations for Lara proposal
5.4 Payback period calculation
5.5 Calculation of the ARR on total assets
5.6 Comparison of various appraisal methods
5.7 Comparison of mutually exclusive projects
5.8 Investment opportunities for Mervtech plc
5.9 NPV vs. PI for Mervtech plc
5.10 Modified IRR for Lara
5.11 Flintoff plc: planned investment schedule
(£000)
5.12 Projects accepted based on LP solution
6.1 Profitability of Sevvie’s project
6.2 Sevvie plc solution
6.3 The money terms approach
45
49
51
55
6.4
6.5
6.6
6.7
6.8
63
64
68
91
94
106
112
124
124
126
128
130
131
133
136
136
139
140
141
152
152
153
6.9
6.10
6.11
8.1
8.2
8.3
8.4
8.5
8.6
8.7
9.1
9.2
9.3
9.4
9.5
9.6
9.7
10.1
10.2
10.3
10.4
The real terms approach
Project Tiger 2000 (assuming no capital
allowances)
Woosnam plc – Tiger 2000 tax reliefs
Woosnam plc – Tiger 2000 with tax relief
Capital investment evaluation methods
in 100 large UK firms
Relationship between ARR and IRR
Allis plc cash flows for two projects
Profit projection for CNC milling
machine (£000)
Betterway plc: expected net present values
Effects of cost structure on profits (£000)
Snowglo plc project data
Project risk for Snowglo plc
UMK cost structure
Risk analysis in 100 large UK firms
Bronson project payoffs with independent
cash flows
Returns under different states of the
economy
Calculating the covariance
Differing returns and risks
Portfolio risk-return combinations (%)
Returns from Gerrybild
Calculation of standard deviations of
returns from each investment
Calculation of the covariance
The annual TSRs on Pilkington shares
How to remove portfolio risk
Possible returns from Walkley Wagons
Beta values of the constituents of
the FT 30 Share Index
154
155
156
157
158
160
164
171
197
199
200
201
205
210
212
224
224
226
226
229
229
230
239
242
245
248
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List of figures and tables
10.5 Equity-gilts relative returns
11.1 The return on Whitbread plc shares
11.2 Cash flow profile for Safa plc
(ungeared)
11.3 Divisional Betas for Whitbread plc
11.4 The effect of operating gearing (£m)
11.5 Subjective risk categories
12.1 Option on BP shares (current price 397p)
12.2 Returns on BP shares and options
12.3 Valuing a call option in Riskitt plc
12.4 Harlequin plc: call option valuation
13.1 Helsinki plc: profitability and risk of
working capital strategies
14.1 Total inventory levels and stockholding
periods
14.2 Thorntons plc consolidated cash flow
statement
14.3 Mangle Ltd: production and sales
14.4 Mangle Ltd: cash budget for six months
to June (£)
15.1 Tax relief on a 3-year HP contract with
4-year asset lifetime (£)
15.2 Hardup plc’s leasing analysis
15.3 The behaviour of the equivalent loan (£m)
15.4 Hardup’s leasing decision with tax
15.5 Interest charges on a lease contract
(figures in £m)
15.6 Changes in tax-allowable lease costs
(figures in £m)
16.1 History of Microsoft common
stock splits
17.1 Kelda Group plc Financial Calendar 2004
252
273
281
285
287
288
300
301
308
313
344
363
369
371
371
391
394
395
399
400
400
431
448
17.2
17.3
17.4
18.1
18.2
18.3
18.4
19.1
19.2
20.1
20.2
20.3
20.4
20.5
20.6
20.7
21.1
21.2
21.3
21.4
22.1
22.2
22.3
22.4
22.5
Rawdon plc
BAA plc: dividend smoothing
Analysis of a share repurchase
Financial data for BAA plc
How gearing affects shareholder returns in
Lindley plc
How gearing affects the risk of ordinary
shares
How gearing can affect share price
Key definitions in capital
structure analysis
The tax shield with finite-life debt
The scale and financing of takeover
activity of UK firms by UK firms
Acquisition according to status of acquiree
Cross-border acquisitions involving UK
companies
Hawk and vole
Strategic opportunities
Pre- and post-bid returns
The gains from mergers
Average rates against sterling
Twelve-month forecasts to
1 November 2000
Oilex’s internal currency flows
Sterling/US$ options
Sparkes and Zoltan: project details
Evaluation of the Zoltan project
Alternative evaluation of Zoltan project
Country risk scores for selected locations
British Airways plc borrowings as at 31
March 2004
xv
460
464
467
483
487
488
489
515
531
543
544
545
551
560
569
570
594
609
615
619
640
641
641
649
653
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Preface
Not all text-books survive to a fifth edition. As one of the lucky survivors, we wish to
preface this edition with another ‘thank you’ – thank you to the lecturers who have
recommended our book and also to the students who have purchased and used it.
Hopefully, you have all obtained good value from it.
We first began work on this project around 1990, a decade and a half ago. Over this
period, there have been many changes in the financial arena. For example, a radical
downshift in inflationary expectations, the formation of the World Trade Organisation,
increasing integration of world financial markets, powered by the ongoing revolution
in communications, the end of the ‘Japanese Miracle’, and the introduction of the euro.
We have seen several financial meltdowns – at the national level, the ‘Asian Crisis’,
Argentina, and at the micro-level, the ‘dotcom’ boom and bust and the crisis in corporate governance.
It is not surprising that financial issues increasingly dominate the news bulletins,
emphasizing the need for both students of business and also business practitioners to
have at least a working knowledge of finance. Yet academic courses are becoming
increasingly fragmented, for example, with the move to semesterisation. At the same
time, within academic courses, the emphasis now placed on formal mathematical and
statistical training, and even economics, is also being reduced.
These considerations reinforce our view that finance should be about developing,
explaining and, above all, applying key concepts and techniques to a broad range of
contemporary management and business policy concerns and challenges. It is becoming more appropriate, certainly at the undergraduate level, to demonstrate the role
finance has to play in explaining and shaping business development rather than concentrating on rigorous, quantitative aspects.
The focus of the fifth edition, as in previous ones, is distinctly corporate, examining
financial issues from a managerial standpoint. To simplify greatly, we have tried, wherever possible, to present the reader with the question ‘OK, but how does this help the
managerial decision-maker?’ and also to provide a few answers, or at least pointers.
Some might say we should include chapters on other financial issues deemed to
have a degree of importance equivalent to those covered here. Yet we believe, as ever,
that there is a trade-off between comprehensiveness and manageability. Admittedly,
this edition has grown a little but it is directed at those issues, which in our experience
are regarded as the central issues in finance.
Distinctive features
The fifth edition retains a set of distinctive features, including the following:
■
■
A strategic focus. Students often regard financial management as a subject quite distinct from management and business policy. We attempt to relate the subject to
these matters, emphasizing the integration of the finance function within the context of managerial decision-making and corporate planning, and to the wider external environment.
A practical approach. Financial theory increasingly dominates some texts. Theory has
its place, and this text covers an appreciable amount; however, we seek to blend theory and practice: to ask why they sometimes differ, and to assess the role of lesssophisticated financial approaches. In other words, we do not elevate theory above
common sense and intuition.
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Preface
■
■
xvii
A clear and accessible style. Personal experience and feedback suggests that much of
our target readership prefers a more descriptive, rather than heavily mathematical,
approach but appreciates worked examples and illustrations. There is a place for
formulae, proofs and quantitative analysis; however, where possible, an alternative
narrative explanation is provided. Appendices are often used to deal with rather
more complex mathematical aspects.
An international perspective. Although emanating from the UK, our text uses, where
appropriate, examples drawn from other regions and countries, especially mainland Europe and the USA.
Teaching and learning features
A range of teaching and learning features is provided, including the following:
■
■
■
■
■
■
■
Mini-case studies. Topical cameos, applying financial management principles to
well-known companies, are presented at the start of chapters and elsewhere within the text.
Learning objectives. Specified at the outset of each chapter, these highlight what the
reader should achieve in terms of concepts, terminology and skills.
Worked examples. Integrated throughout the text to illustrate the key principles.
Extracts from the press. Each chapter includes at least one article from either the
Financial Times or the Economist focusing on one of the key issues addressed in the
chapter.
Key revision points. Provided at the end of each chapter to summarize the main concepts covered.
Annotated further reading. At the end of each chapter, a number of key books and articles are suggested to offer additional perspectives and enable subjects to be studied
in more depth. Full details of all books and articles are given in the References at the
end of the book.
A quick reference glossary of simple definitions.
Assessment features
Flexible study and assessment is facilitated by a variety of activities:
■
■
■
Self-assessment activities (SAAs). These include both short questions and simple
numerical exercises designed to reinforce a point made in the text or to encourage
the reader to pursue a particular line of thought. However, they are presented differently and consistently in this edition. Questions are inserted in the text at appropriate points and the answers are packaged together at the end of the book.
Questions. These test a mix of numerical, analytical and descriptive skills, offering a
spread of difficulty. A selection of solutions is also provided in Appendix A at the
end of the text, making these suitable for self-assessment, tutorial or examination
purposes.
Practical assignments. These provide the opportunity to look beyond the confines of
the text to consider the application of concepts to a company or organization, or to
published financial reports and data, and are suitable where group or individually
assessed coursework is set.
Readership
The text has proved successful both for newcomers to finance and also for students
with a prior knowledge of the subject. It is particularly relevant to undergraduate,
MBA and other postgraduate and post-experience courses in corporate finance or
financial management. Students seeking a professionally accredited qualification
will also find it especially relevant to the financial management papers of the
Association of Chartered Certified Accountants, Institute of Chartered Secretaries
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xviii Preface
and Administrators, Certified Diploma in Finance and Accounting, Chartered
Institute of Management Accountants and the Institute of Chartered Accountants in
England and Wales.
Changes to the fifth edition
As with previous editions, our revisions are based on extensive market research
including reviewers’ questionnaires and direct feedback from adopters and users.
Feedback, while always interesting and helpful, was sometimes contradictory.
Some wished for a more comprehensive, and sometimes more rigorous treatment,
while others expressed concern that we might lean too far in the direction of strategy. Hopefully, we have achieved a balance between academic rigour and practical application.
In preparing this edition, we have battled with two opposing forces. We wanted to
avoid expanding the text to an unmanageable size, yet we have been aware of several
gaps in our coverage in previous editions, and the need for ‘infill’.
The main changes to this edition in structure and in content are:
Structural changes
Following comments by reviewers (although not unanimous!), we decided to consolidate much on the international material into a whole new Part – Part VI International
finance. This includes the old Chapter 17 on Managing currency risk, that appeared in
Part IV, and also the old Chapter 8 on Foreign investment decisions. This consolidation
has the major advantage of enabling us to draw upon prior treatments of concepts/
theories such as PPP and IRP when we handle FDI, rather than attempting to cover
these in ‘broad-brush’ form as we did in the old Chapter 8. Consequently, the old
Section 8.6 (entitled ‘Should firms worry about exchange rate changes?’) has been
incorporated into the new Chapter 21. The new Chapter 22 now incorporates sections
that were previously dispersed across other chapters – specifically, the old Sections
20.9 (International financing) and 20.10 (The WACC for foreign investment projects),
and 21.10 (Applying the APV to foreign investment decisions).
However, we decided that the material on insuring and financing international
trade, the old Section 16.11 (Financing international trade), still properly belongs within the chapter on short- and medium-term finance (the new Chapter 15).
There is now a new Chapter 23 that provides an overview on the ‘state of the art’ in
corporate financial management, and offers important perspectives on the field from
the standpoint of behavioural finance. It thus offers insights into the possible directions that future developments in this subject might take.
Changes in content
As well as routine revisions and updating, especially of introductory and in-chapter
cameos, we have made the following changes:
The treatment of EVA has been revised and strengthened in Chapter 4, and extended to cover geared firms in Chapter 18 (formerly Chapter 20).
There is now a new section in Chapter 10 (old Chapter 11) on factor models.
The material in Chapter 12 (formerly Chapter 13) on strategic options has been
strengthened.
Chapter 19 (formerly Chapter 21) now includes a section (Section 21.7 Linking the
Betas) that clarifies the relationship between the various concepts of Beta.
Chapter 20 on Acquisitions and restructuring has been updated to include material
on the new EU Mergers Directive.
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Preface
xix
Structure and outline
An outline of the text is given below; however, a further description of the purpose
and content of each section is given in the introduction to each.
Part I considers the underlying framework for corporate financing and investment
decisions; key aspects of this part are the financial objectives of business, the financial
environment within which firms operate, the time value of money and the concept of
value.
Part II addresses investment decisions and strategies within firms. Emphasis is
placed on evaluation procedures, including treatments of taxation, inflation and capital rationing. Because, in practice, investment decision-making often bears little relationship to the theoretical approaches outlined in some texts, we persist in our
attempt to promote an understanding of the practical evaluation of investment decisions by firms.
The importance of risk management is examined in Part III. Five chapters are
devoted to analysing and managing investment risk: the first considers the investment
project in isolation, while other chapters view risk more from a shareholder perspective. Fundamental to this section and to the whole of financial management is the rate
of return on investment required by shareholders. The rapidly developing and exciting field of options analysis is also explored.
Part IV discusses the short-term financing decisions and policies for acquiring
assets. It covers treasury and working capital management.
Part V addresses long-term, strategic financing and policy issues. What are the main
sources of finance? How much should a company pay in dividends? How much
should it borrow? The culminating chapter focuses on corporate restructuring with
particular reference to acquisitions.
Part VI examines international financial management issues. It explains the operation of the foreign currency markets and how firms can hedge against adverse foreign
exchange movements, and sets out the principles underpinning firms’ evaluation of
foreign investment decisions.
Companion website
This edition is supported by a companion website, at www.pearsoned.co.uk/pikeneale.
This contains much of the material that we have included in previous instructors’
manuals. It provides answers to all the end-of-chapter questions, plus additional questions and answers. The case exercises previously included in Chapter 23 of the third
edition also appear there. It also reproduces the glossary.
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Guided tour of the book
Part
III
INVESTMENT RISK AND RETURN
The preceding analysis of investment decisions has implied that future returns from investment can
be forecast with certainty. Clearly, this is unlikely in practice. In Part III we examine the impact of
uncertainty on the investment decision, and the various approaches available to decision-makers to
cope with this problem.
In Chapter 8, we discuss a number of methods that may assist the decision-maker when looking at
the risky investment project in isolation. In Chapter 9, we look at how more desirable combinations
of risk and return can be achieved by forming a portfolio of investment activities. In Chapter 10, we
examine the contribution to risk analysis of the Capital Asset Pricing Model, which offers a guide to
setting the premium required for risk. The earlier study of how capital markets behave is particularly
important here. Chapter 10 is highly important because it links the behaviour of individual investors,
buying and selling securities, to the behaviour of the capital investment decision-maker. This focus is
further developed in Chapter 11, which discusses how to alter the discount rate when faced by
projects of degrees of risk that differ from the company’s existing activities. Finally, in Chapter 12,
we look at the contribution to investment appraisal under risk promised by the rapidly developing
field of option analysis.
Chapter 8
Analysing investment risk
Chapter 9
Relationships between investments: portfolio theory
The book is divided into six parts, each with a full page
introduction and chapter information to help you navigate
around the book.
195
219
Chapter 10 Setting the risk premium: the Capital Asset Pricing Model
237
Chapter 11 The required rate of return on investment and shareholder
value analysis 271
Chapter 12 Identifying and valuing options
296
14
Short-term asset management
SOS from ASOS: from hero to zero
Topical cameos open each chapter, applying financial
management principles to well-known companies.
Mini-case studies also appear throughout the book.
For retailers, the most important current asset is
stock. Failure to have on hand the right amount of
stock at the right time results in lost opportunities to
make profits. For a clothing retailer, this is especially
important if the product quickly goes out of fashion,
as these opportunities may never reappear.
ASOS (formerly As Seen On Screen), the online fashion retailer that specialises in selling celebrity-style
clothes to 20-something shoppers, was the top performer on the London Stock Exchange during 2004,
when its shares rose from 5p to 78p. However, in March
2005, it was forced to issue a profits warning. As a result
of problems with distribution of merchandise, winter
stock that should have been sold over Christmas had
become backed up, necessitating sharp price cuts to
shift excess produce. ASOS’s Chief Executive said that:
This discounting had led to a significant increase in
sales, well beyond budgeted levels. As a consequence,
Learning objectives highlight what you should expect
to achieve from each chapter in terms of concepts,
terminology and skills.
we are bearing the costs associated with very high
sales volumes, but without the gross margin to support them.
In fact, average gross margin fell from 50% to about
30%. He added that ASOS would have done even better than its 70% sales leap over Christmas, had it not
been working out of four dispersed warehouses, when
it needed a centralised strategic site. The difficulties in
coordinating distribution resulted in delays in items
appearing on the ASOS website, causing the backlog of
stock. Happily, he was able to report the appointment
of a new general manager to oversee distribution, and
that ASOS had found a 70,000 sq. ft. warehouse
expected to come into use in three months. This
mixed message probably helped to moderate the
market’s reaction to the profit warning, limiting the
share price fall to 11%.
Source: Based on article by Lisa Urquhart, Financial Times, 4 March 2005.
Learning objectives
Having read this chapter, you should have a good appreciation of the importance of short-term
asset management in corporate finance and of the basic control methods involved. Specific attention will be paid to the following:
■
Managing trade credit.
■
Inventory management.
■
Cash management.
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.
Chapter 13 Treasury Management and working capital policy
Topical articles on real-world examples taken from the financial
press, including the Financial Times, bring the subject to life.
Self-assessment activities reinforce points made in the text, and
encourage self-learning. Answers are found in Appendix A at the
back of the book.
Not everyone likes derivatives
Warren Buffet, the so-called ‘Sage of Omaha’, has an excellent track record in managing
his investment vehicle, Berkshire Hathaway, having outperformed the S&P 500 index in 34
of the past 39 years (up to 2003). His success is based largely on sticking to firms that
produce simple basic products for which there is always likely to be a demand. ‘If you
don’t understand it, don’t invest in it’ is one of his mottos – he is famed for not investing
in technology stocks during the internet boom.
He is also very scathing about the relative freedom of companies and dealers to value
positions in swaps, options and other complex products whose prices are not listed on
exchanges, thus giving a potentially misleading picture of a firm’s true future liabilities.
According to Buffet, derivatives are ‘Weapons of Mass Financial Destruction’, time bombs
waiting to explode in the faces of the parties that deal in them, and for the whole economic system. Designed as risk management devices, he says they actually pose risks that central banks and governments have so far found no effective way to control, or even monitor.
Key terms are highlighted in the text where they first appear,
with definitions in the margin. The full glossary also appears in the
back of the book and on the Student Companion Website at
www.pearsoned.co.uk/pikeneale.
Source: Based on Warren Buffet’s annual letter to shareholders, as reported in an article in the Economist, 15 March 2003.
Self-assessment activity 13.5
Define in your own words the main forms of derivatives – forwards, futures, swaps and options.
(Answer in Appendix A at the back of the book)
13.7
Chapter 2 The financial environment
WORKING CAPITAL MANAGEMENT
net working capital
47
337
(e) Interest rate options. Also termed interest rate guarantees, these contracts grant the
buyer the right but not the obligation to deal at a specific interest rate at some
future date.
(f) Interest rate ‘swaps’. These occur where a company (usually very large firms) with
predominantly variable rate debt, worried about a rise in rates, ‘swaps’ or matches its debt with a company with predominantly fixed-rate debt concerned that
rates may fall. A bank usually acts as intermediary in the process, but it can be
through direct negotiations with another company. Each borrower will still remain
responsible for the original loan obligations incurred. Typically, firms continue to
pay the interest on their own loan and then, at the end of the agreed period, a cash
adjustment will be made between the two parties to the swap agreement. Interest
rate swaps can also involve exchanges in different currencies.
Current assets less current
liabilities
Self-assessment activity 2.8
Explain why it is important to consider the tax implications of financial and investment
decisions.
The last main area of treasury management is the management of working capital,
including liquidity management. We devote the remainder of this chapter to working
capital policy and the following chapter to short-term asset management. Let us first
clarify the basic terms and ratios employed in working capital management.
Net working capital (or simply working capital) refers to current assets less current
liabilities – hence its alternative name of net current assets. Current assets include
cash, marketable securities, debtors and stock. Current liabilities are obligations that
are expected to be repaid within the year.
Working capital management refers to the financing, investment and control of net
current assets within policy guidelines. The treasurer acts as a steward of corporate
resources and needs to devise and operate clear and effective working capital policies.
(Answer in Appendix A at the back of the book)
SUMMARY
This chapter has introduced readers to the financial and tax environment within which
financial and investment decisions take place.
Key points
■
Financial markets consist of numerous specialist markets where financial transactions occur (e.g. the money market, capital market, foreign exchange market, derivatives markets).
■
Financial institutions (e.g. banks, building societies, pension funds) provide a vital
service by acting as financial intermediaries between savers and borrowers.
■
Securitisation and disintermediation have permitted larger companies to create
alternative, more flexible forms of finance.
■
The London Stock Exchange operates two tiers: the Main List for larger established
companies, and the Alternative Investment Market which mainly caters for very
young companies.
■
An efficient capital market is one where investors are rational and share prices
reflect all available information. The Efficient Markets Hypothesis has been examined in its various forms (weak, semi-strong and strong). In all but the strong form,
it seems to hold up reasonably well, but it is increasingly unable to explain ‘special’
circumstances.
■
The problem of ‘short-termism’ may stem more from managerial attitudes than
those of investors.
■
Taxation can play a key role in financial management, particularly in raising
finance, investing in fixed assets and paying dividends.
Summaries and Key points appear at the end of each
chapter to give a reminder of main concepts covered.
Further reading suggestions are made to enable topics to
be studied in more depth.
Chapter 7 Investment strategy and process
Further reading
Brett (2003) provides a clear explanation of how to read the financial pages in the press. Clear
and more extensive introductions to capital markets are found in Foley (1991), and Weston
Copeland (1992), O’Shea (1986) and Redhead (1990).
The Stock Exchange Fact Book is published annually by the Stock Exchange. Two classic review
articles on market efficiency were written by Fama (1970 and 1992), while Rappaport (1987)
examines the implications for managers. Tests of capital market efficiency are found in Copeland
and Weston (2004) and Keane (1983), while some exceptions to efficiency are found in the June
1977 special issue of Journal of Financial Economics. Peters (1991, 1993) applies Chaos Theory
to stock markets. Discussion on short-termism in the City is found in Marsh (1990) and Ball
(1991). Mastering Finance (1997) offers useful articles on securitisation, financial intermediaries,
the role of financial markets, market efficiency and short-termism.
Questions at the end of each chapter test a mix of numerical,
analytical and descriptive skills. Many of the questions are taken from
the examination papers of professional bodies such as CIMA and
ACCA. Selected answers can be found in Appendix B at the back of
the book.
Practical assignments consider the application of concepts to a
company, organisation or published report.
Additional Quests can be found on the Student Companion Website
at www.pearsoned.co.uk/pikeneale, providing the opportunity to
seek out information and apply what you have learnt.
QUESTIONS
Questions with a coloured number have solutions in Appendix B on page 695.
1 ‘Capital budgeting is simply a matter of selecting the right decision rule.’ How true is this statement?
2 What are the aims of post-audits?
3 AMT plc is increasing the level of automation of a production line dedicated to a single product. The options
available are total automation or partial automation. The company works on a planning horizon of five years
and either option will produce the 10,000 units which can be sold annually.
Total automation will involve a total capital cost of £1 million. Material costs will be £12 per unit and labour
and variable overheads will be £18 per unit with this method.
Partial automation will result in higher material wastage and an average cost of £14 per unit. Labour and
variable overhead are expected to cost £41 per unit. The capital cost of this alternative is £250,000.
The products sell for £75 each, whichever method of production is adopted. The scrap value of the automated production line, in five years’ time, will be £100,000, while the line which is partially automated will
be worthless. The management uses straight-line depreciation and the required rate of return on capital
investment is 16 per cent p.a. Depreciation is considered to be the only incremental fixed cost.
In analysing investment opportunities of this type the company calculates the average total cost per unit,
annual net profit, the break-even volume per year and the discounted net present value.
Required
(a) Determine the figures which would be circulated to the management of AMT plc in order to assist their
investment analysis.
(b) Comment on the figures produced and make a recommendation with any qualifications you think appropriate.
(Certified Diploma)
4 Bowers Holdings plc has recently acquired a controlling interest in Shaldon Engineering plc, which produces
high-quality machine tools for the European market. Following this acquisition, the internal audit department
of Bowers Holdings plc examined the financial management systems of the newly acquired company and produced a report that was critical of its investment appraisal procedures.
The report summary stated:
Overall, investment appraisal procedures in Shaldon Engineering plc are very weak. Evaluation of capital
projects is not undertaken in a systematic manner and post-decision controls relating to capital projects are
virtually non-existent.
Required
Prepare a report for the directors of Shaldon Engineering plc, stating what you consider to be the major
characteristics of a system for evaluating, monitoring and controlling capital expenditure projects.
(Certified Diploma)
What procedures should a business adopt for approving and reviewing large capital expenditure projects?
Practical assignment
Read the Harvard Business Review article (Sept.–Oct. 1989) ‘Must finance and strategy clash?’ by Barwise, Marsh
and Wensley. Summarise and comment on their views on the question.
191
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Guided tour of the website
A Summary for each chapter can be found on
the Student Companion Website at
www.pearsoned.com/pikeneale, to give a
reminder of the main points covered.
For each chapter there are Multiple Choice,
True/False and Fill-in-the-blank Questions,
giving you the chance to check your progress
and get instant feedback.
Useful Websites are listed at
the end of each chapter, and
Weblinks to these sites are
provided on the Student
Companion Website.
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Acknowledgements
All textbooks include ‘acknowledgements’ but, on reflection, this seems too weak a
word to use when assistance has so often been so freely given. Roget’s Thesaurus
offers as a synonym, ‘the act of admitting to something’, suggesting rather grudging
recognition!
Our recognition of the wide range of people and organizations is anything but
grudging. We extend our warm appreciation of the helpful comments provided by
you over the years, and also for consent to use your material.
To the ever-lengthening roll of honour, we wish to add the following names and
organizations, whom we sincerely hope will be happy to be associated with our efforts:
Andrew Barfield
Maxim Kakareka
Professor Colin Mason – University of Strathclyde
Professor Andrew Marshall, University of Strathclyde
Sue Lane
Peter Blankenhorn – E.On AG
Andrew Naughton-Doe – Corus UK plc
Pat Rowham – LBS
Peter Aubusson – DS Smith plc
Sue Cox – BAA plc
ASJR Ramsay – International Power plc
“Sarah” at British Airways plc
Jane Lanyon – Thorntons plc
Ian Lomas – DTI
Ian Patterson – HM Customs & Excise
As ever, we apologise for any omissions.
Finally, we are especially grateful to the ever-patient, ever-tolerant editorial staff at
Pearson Education, and to the anonymous contributors to the market research
conducted by the publisher. We hope that you will agree that your comments have led
to an improvement in the quality of the final product. Naturally, as ever, we claim sole
responsibility for any remaining errors.
Richard Pike, University of Bradford
Bill Neale, Bournemouth University
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Publisher’s Acknowledgements
We are grateful to the Financial Times Limited for permission to reprint the following material:
A manager’s real responsibility, © Financial Times, 30 January 2002; Inion plans £30m public
offering, © Financial Times, 10 November 2004; Table 2.2 Table of food retail sector share prices,
© Financial Times, 11 January 2005; Back to the Future, © Financial Times, 23 December 2004;
Capturing the indefinable value of a brand, © Financial Times, 9 February 2005; The Japanese art
of performance, © Financial Times, 18 May 2004; Nalco plans $2 billion smelter in Qatar,
© Financial Times, 21 March 2002; The big gamble: Airbus rolls out its new weapon in its battle
with Boeing, © Financial Times, 17 January 2005; Lex live: Metro and the weather, FT.com,
© Financial Times, 30 October 2004; Lex column: Counting the cost, FT.com, © Financial Times, 24
March 2003; Shareholders want their cash handed back to them, © Financial Times, 15 September
2004; BMW bets on rebound for falling US dollar, © Financial Times, 18 March 2004; Table 21.4
Table of share prices, © Financial Times, 4 January 2005; Lex: Deutsche Telekom, © Financial Times,
12 November 2004; Sistema in record $1.3bn flotation, © Financial Times, 10 February 2005; Coral
Eurobet makes £400m capital return, © Financial Times, 1 December 2004; Boots to generate
£300m in sale and leaseback, © Financial Times, 25 January 2005; Vodaphone doubles its dividend
pay-out, © Financial Times, 17 November 2004; Rosy view of share buybacks ignores paucity of
investment opportunities, © Financial Times, 11 and 12 September 2004; Cable and wireless,
© Financial Times, 11 November 2004; Silicon Valley is starting to return cash to investors,
© Financial Times, 14 March 2005; Trump to stay as hotels group files for Chap 11, © Financial
Times, 23 November 2004; BA to raise £435m in sale of Qantas stake, FT.com, © Financial Times, 8
September 2004; News Corp unveils poison pill defence strategy, © Financial Times, 9 November
2004; Acquisitions in US ‘disastrous’ for British companies, © Financial Times, 11 October 2004;
IPO revival helps buy-outs to four-year high, © Financial Times, 4 January 2005; Investors show
various traits of behaviour, © Financial Times, 27 March 2004.
We are grateful to the following for permission to use copyright material:
Corus plc for permission to use an extract from their 2004 Annual Report; DS Smith plc for
permission to use an extract from their 2004 Annual Report and Accounts; The Economist
Newspaper Limited for the article ‘Investing in Indonesia: At a crossroads’ published in The
Economist 8th May 2004 © The Economist Newspaper Limited, London, 2004; Tomkins plc for an
extract from Tomkins plc Reports and Accounts 2003; New risks put scenario planning in favour
from Financial Times Limited, 19 August 2003, © Awi Federgruen and Garrett Van Ryzin; Watch
the herd, but don’t join it from The Financial Times Limited, 3 July 2004, © Brian Bloch; Powering
ahead is from a circular sent to International Power shareholders, August 2004, reproduced by
permission of International Power plc; Figure 10.1 from Pilkington plc Director’s Report &
Accounts 2004 reproduced by permission; Figure 10.4 from Financial Reform and Institutions,
Poznań University of Economics, T. Kowalski and S. Letza (eds), T. Short (2000). Reproduced by
permission of the editors; Table 18.1 from the BAA plc Annual Report for the year ending 31
March 2004, with permission from BAA; Figure 22.1 Reprinted from European Management
Journal, Vol 22, No 1, Grant, R., & Soenen, L., Strategic Management of Operating Exposure, pp.
353–62 Copyright 2004, with permission from Elsevier.
In some instances we have been unable to trace the owners of copyright material, and we would
appreciate any information that would enable us to do so.
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FORMULAE, EQUATIONS AND DEFINITIONS
DEFINITIONS
B book value of debt
b proportion of earnings retained by a firm
bg Beta geared
bj asset or activity Beta for company j
bu Beta ungeared
Covij, or sij, the covariance of returns on the shares of companies i and j
Covjm, or sjm, the covariance of returns on the shares of companies j and the return on the market portfolio.
D0 dividend per share at time zero
E t earnings in year t, equal to free cash flow if expressed net of replacement investment
ER j required return on the shares of company j 1 ke 2
ER m expected return on the market portfolio
ER p expected return on a specified portfolio
EV expected value
F0 forward rate of exchange for delivery in one period’s time
FV future value
g annual rate of growth in dividends and earnings 1b R2
i rate of interest
I expected rate of inflation
k required rate of return
kd cost of debt
ke rate of return required by shareholders
k0 Weighted Average Cost of Capital (WACC) (overall cost of capital)
M money, or nominal, required return (also used to denote the market portfolio)
sj standard deviation of the return on company j’s shares
sj2 variance of the return on company j’s shares
sm standard deviation of the return on the market portfolio
sp standard deviation of the return on a specified portfolio
P:E Ratio 1PER2 1Profit After Tax>Earnings per Share2
P0 share price at time zero
PVIF1i,n2 present value interest factor for single payment at i% after n years
PVIFA1i,n2 present value interest factor for an annuity at i% for n years
R rate of return on re-invested earnings, also used for real cost of capital
R f rate of return on a risk-free asset
R jt Total Shareholder Return for company j in time period t
R m actual return on the market portfolio
R p actual return on a specified portfolio
rij the correlation coefficient between the returns on the shares of company i and company j respectively.
rjm the correlation coefficient between the returns on the shares of company j and the return on the market portfolio.
S 0 today’s spot rate of exchange
S 1 expected spot rate of exchange in time period 1.
T rate of tax on corporate profits, or Tc
Tp rate of tax on personal income
TB Tax Shield
VB Market Value of debt (borrowings)
Vg Value of a geared firm
V0 Value of whole firm at time zero enterprise value
VS Market Value of Shares
Vu Value of an ungeared firm value of equity in the firm
Xt Net Cash Inflow in year t.
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Part
I
A FRAMEWORK FOR
FINANCIAL DECISIONS
Business financial decisions are not made in a vacuum. An ‘obvious’ decision may often have to be
tempered by an appreciation of the restrictions imposed by the prevailing environment. Although it
is beyond our scope to consider the full social, political and economic complexity of the financial
decision-making context, we provide an overview of the key features of the UK financial and
economic system. A sound grasp of the framework for financial decisions is essential if the reader is
to appreciate fully the issues discussed in subsequent chapters of this book.
Part I provides an introduction to the scope and the fundamental concepts of financial management, Chapter 1 provides a broad picture of the subject and the important role it plays in business.
It examines the nature of financing and investment decisions, the role of the financial manager and
the fundamental objective for corporate financial management. This leads on, in Chapter 2, to
consideration of the financial and tax environment in which businesses operate. Particular attention
is devoted to the characteristics and operation of the London Stock Exchange, which provides a
barometer of the success of financial decisions via the market’s valuation of the company’s shares.
The extent to which any market can provide ‘accurate’ valuations is also considered.
Central concepts in financial management are the time-value of money and present value, which are
discussed in Chapter 3. These ideas are developed in Chapter 4 to provide an understanding of
valuation. Concepts of value and its measurement play important roles in subsequent chapters,
where investment, financing and other key decisions are discussed.
Chapter 1
An overview of financial management
Chapter 2
The financial environment
Chapter 3
Present values and financial arithmetic
Chapter 4
Valuation of assets, shares and companies
3
24
38
66
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1
An overview of financial management
Working for shareholders
Tomkins plc, the international engineering and manufacturing group, has enjoyed one of the fastest growth
rates over the past thirty years. What are the main objectives for such a company? The chairman, in his statement on the 2003 accounts, makes it clear:
‘Our principal objective must be to achieve long term sustainable growth in the economic value of
Tomkins through strategic development of our businesses. Through effective communication to the financial markets, this translates into growth in equity value for our shareholders.’
Source: Tomkins plc Report & Accounts, 2003.
Learning objectives
By the end of this chapter, you should understand the following:
■
What corporate finance and investment decisions involve.
■
How financial management has evolved.
■
The finance function and how it relates to its wider environment and to strategic planning.
■
The central role of cash in business.
■
The goal of shareholder wealth creation and how investors can encourage managers to adopt
this goal.
■
The underlying principles of finance.
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4 Part I A framework for financial decisions
1.1
INTRODUCTION
The Tomkins plc mission statement, summarised at the start, suggests that its management has a clear idea of its purpose and key objectives. Its mission is to deliver economic value to its shareholders in the form of dividend and capital growth. An
organisation such as Tomkins, with a broad range of products, understands the importance of meeting the requirements of its existing and potential customers. But it also
recognises that the most important ‘customers’ are the shareholders – the owners of the
business. Its objectives, strategies and decisions are all directed towards creating value
for them.
One of the challenges in any business is to make investments that consistently yield
rates of return to shareholders in excess of the cost of financing those projects and better than the competition. This book centres on that very issue: how can firms create value
through sound investment decisions and financial strategies?
This chapter provides a broad picture of financial management and the fundamental role it plays in achieving financial objectives and operating successful businesses.
First, we consider where financial management fits into the strategic planning process
for a new business. This leads to an outline of the finance function and the role of the
financial manager, and what objectives he or she may follow. Central to the subject is
the nature of these financial objectives and how they affect shareholders’ interests.
Finally, we introduce the underlying principles of finance, that are developed in later
chapters.
■
Starting a business: Brownbake Ltd
Ken Brown, a recent business graduate, decides to set up his own small bakery business. He recognises that a clear business strategy is required, giving a broad thrust to
be adopted in achieving his objectives. The main issues are market identification, competitor analysis and business formation. He identifies a suitable market with room for
a new entrant and develops a range of bakery products that are expected to stand up
well, in terms of price and quality, against the existing competition.
Brown and his wife become the directors of a newly formed limited company,
Brownbake Ltd. This form of organisation has a number of advantages not found in a
sole proprietorship or partnership:
■
■
■
■
Limited liability. The financial liability of the owners is limited to the amount they
have paid in. Should the company become insolvent, those with outstanding claims
on the company cannot compel the owners to pay in further capital.
Transferability of ownership. It is generally easier to sell shares in a company, particularly if it is listed on a stock market, than to sell all or part of a partnership or sole
proprietorship.
Permanence. A company has a legal identity quite separate from its owners. Its existence is unaffected by the sale of shares or death of a shareholder.
Access to markets. The above benefits, together with the fact that companies enable
large numbers of shareholders to participate, mean that companies can enjoy financial economies of scale, giving rise to greater choice and lower costs of financing the
business.
Brown should have a clear idea of why the business exists and its financial and
other objectives. He must now concentrate on how the business strategy is to be implemented. This requires careful planning of the decisions to be taken and their effect on
the business. Planning requires answers to some important questions. What resources
are required? Does the business require premises, equipment, vehicles and material to
produce and deliver the product?
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Chapter 1 An overview of financial management
5
The key to industrial capitalism: limited liability
Shares or ‘equities’ were first issued in the 16th century, by Europe’s new joint-stock companies,
led by the Muscovy Company, set up in London in 1553 to trade with Russia. (Bonds, from the
French government, made their debut in 1555.) Equity’s popularity waxed and waned over the
next 300 years or so, soaring with the South Sea and Mississippi bubbles, then slumping, after
both burst in 1720. But share-owning was mainly a gamble for the wealthy few, though by the
early 19th century in London, Amsterdam and New York trading had moved from the coffee
houses into specialised exchanges. Yet the key to the future was already there. In 1811, from
America, came the first limited-liability law. In 1854, Britain, the world’s leading economic
power, introduced similar legislation.
The concept of limited liability, whereby the shareholders are not liable, in the last resort,
for the debts of their company, can be traced back to the Romans. But it was rarely used, most
often being granted only as a special favour to friends by those in power.
Before limited liability, shareholders risked going bust, even into a debtors’ prison maybe, if
their company did. Few would buy shares in a firm unless they knew its managers well and
could monitor their activities, especially their borrowing, closely. Now, quite passive investors
could afford to risk capital – but only what they chose – with entrepreneurs. This unlocked vast
sums previously put in safe investments; it also freed new companies from the burden of
fixed-interest debt. The way was open to finance the mounting capital needs of the new railways and factories that were to transform the world.
Source: Based on The Economist, 31 December 1999.
Once these issues have been addressed, an important further question is: how will
such plans be funded? However sympathetic his bank manager, Brown will probably
need to find other investors to carry a large part of the business risk. Eventually, these
operating plans must be translated into financial plans, giving a clear indication of the
investment required and the intended sources of finance. Brown will also need to
establish an appropriate finance and accounting function (even if he does it himself),
to keep informed of financial progress in achieving plans and ensure that there is
always sufficient cash to pay the bills and to implement plans. Such issues are the principal concern of financial management, which applies equally to small businesses, like
Brownbake Ltd, and large multinational corporations, like Tomkins plc.
1.2
THE FINANCE FUNCTION
In a well-organised business, each section should arrange its activities to maximise its
contribution towards the attainment of corporate goals. The finance function is very
sharply focused, its activities being specific to the financial aspects of management
decisions. Figure 1.1 illustrates how the accounting and finance functions may be structured in a large company. This book focuses primarily on the roles of finance director
and treasurer.
It is the task of those within the finance function to plan, raise and use funds in an
efficient manner to achieve corporate financial objectives. Two central activities are as
follows:
1 Providing the link between the business and the wider financial environment.
2 Investment and financial analysis and decision-making.
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6 Part I A framework for financial decisions
Finance Director
or Chief Financial Officer
Responsibilities:
• Financial strategy and policy
• Corporate planning
Figure 1.1
The finance function in
a large organisation
■
Controller
or Chief Accountant
Treasurer
or Financial Manager
Responsibilities:
• Financial accounts
• Management accounts
• Investment appraisal
• Taxes
Responsibilities:
• Risk management
• Funding
• Cash management
• Banking relationships
• Mergers and takeovers
Link with financial environment
The finance function provides the link between the firm and the financial markets in
which funds are raised and the company’s shares and other financial instruments are
traded. The financial manager, whether a corporate treasurer in a multinational company or the sole trader of a small business, acts as the vital link between financial markets and the firm. Corporate finance is therefore as much about understanding financial
markets as it is about good financial management within the business. We examine
financial markets in Chapter 2.
1.3
INVESTMENT AND FINANCIAL DECISIONS
Financial management is primarily concerned with investment and financing decisions
and the interactions between them. These two broad areas lie at the heart of financial
management theory and practice. Let us first be clear what we mean by these decisions.
The investment decision, sometimes referred to as the capital budgeting decision, is
the decision to acquire assets. Most of these assets will be real assets employed within
the business to produce goods or services to satisfy consumer demand. Real assets
may be tangible (e.g. land and buildings, plant and equipment, and stocks) or intangible (e.g. patents, trademarks and ‘know-how’). Sometimes a firm may invest in
financial assets outside the business, in the form of short-term securities and deposits.
The basic problems relating to investments are as follows:
1 How much should the firm invest?
2 In which projects should the firm invest (fixed or current, tangible or intangible, real
or financial)? Investment need not be purely internal. Acquisitions represent a form
of external investment.
The financing decision addresses the problems of how much capital should be raised
to fund the firm’s operations (both existing and proposed), and what the best mix of
financing is. In the same way that a firm can hold financial assets (e.g. investing in
shares of other companies or lending to banks), it can also sell claims on its own real
assets, by issuing shares, raising loans, undertaking lease obligations etc. A financial
security, such as a share, gives the holder a claim on the future profits in the form of a
dividend, while a bond (or loan) gives the holder a claim in the form of interest
payable. Financing and investment decisions are therefore closely related.
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Chapter 1 An overview of financial management
7
Self-assessment activity 1.1
Take a look at the balance sheet of Brownbake Ltd.
Assets employed
Machinery and equipment
Vehicles
Patents
Stocks
Debtors
Cash and building society deposit
£
15,000
8,000
12,000
10,000
3,000
4,000
52,000
Liabilities and shareholders’ funds
Trade creditors
Loans
Shareholders’ equity
12,000
8,000
32,000
52,000
Identify the tangible real assets, intangible assets and financial assets. Who has financial claims
on these assets?
(Answer in Appendix A at the back of the book)
1.4
CASH – THE LIFEBLOOD OF THE BUSINESS
Central to the whole of finance is the generation and management of cash. Figure 1.2
illustrates the flow of cash for a typical manufacturing business. Rather like the
bloodstream in a living body, cash is viewed as the ‘lifeblood’ of the business, flowing to all essential parts of the corporate body. If at any point the cash fails to flow
properly, a ‘clot’ occurs that can damage the business and, if not addressed in time,
can prove fatal!
Good cash management therefore lies at the heart of a healthy business. Let us now
consider the major sources and uses of cash for a typical business.
Financing
Operations
Shareholders’
funds
Customers
Goods or
services
sold
Loans and
supplier credit
Materials
Labour
Overheads
CASH
Capital
investment
Government
Figure 1.2
Cash – the lifeblood
of the business
Dividends, interest, loan repayment
and taxes
Divestment
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8 Part I A framework for financial decisions
■
Sources and uses of cash
Shareholders’ funds
Shareholders’ funds/equity
capital
Money invested by shareholders or profits retained in the
company
The largest proportion of long-term finance is usually provided by shareholders and is
termed shareholders’ funds or equity capital. By purchasing a portion of, or shares in, a
company, almost anyone can become a shareholder with some degree of control over a
company.
Ordinary share capital is the main source of new money from shareholders. They
are entitled both to participate in the business through voting in general meetings and
to receive dividends out of profits. As owners of the business, the ordinary shareholders bear the greatest risk, but enjoy the main fruits of success in the form of dividends
and share price growth.
Retained profits
For an established business, the majority of equity funds will normally be internally
generated from successful trading. Any profits remaining after deducting operating
costs, interest payments, taxation and dividends are reinvested in the business (i.e.
ploughed back) and regarded as part of the equity capital. As the business reinvests its
cash surpluses, it grows and creates value for its owners. The purpose of the business
is to do just that – create value for the owners.
Loan capital
Debt finance/loan capital
Capital raised with an obligation to pay interest and repay
principal
Gearing
Proportion of the total capital
that is borrowed
Money lent to a business by third parties is termed debt finance or loan capital. Most
companies borrow money on a long-term basis by issuing loan stocks (or debentures).
The terms of the loan will specify the amount of the loan, rate of interest and date of
payment, redemption date, and method of repayment. Loan stock carries a lower risk
than equity capital and, hence, offers a lower return.
The finance manager will monitor the long-term financial structure by examining
the relationship between loan capital, where interest and loan repayments are contractually obligatory, and ordinary share capital, where dividend payment is at the discretion of directors. This relationship is termed gearing (known in the USA as leverage).
Government
Governments and the European Union (EU) provide various financial incentives and
grants to the business community. A major cash outflow for successful businesses will
be taxation.
We now turn from longer-term sources of cash to the more regular cash flows from
business operations. Cash flows from operations comprise cash collected from customers
less payments to suppliers for goods and services received, employees for wages and
other benefits, and other operating expenses. Further cash flows include payments to
the government for taxes and to shareholders and lenders for dividends and interest.
1.5
THE EMERGENCE OF FINANCIAL MANAGEMENT
While aspects of finance, such as the use of compound interest in trading, can be traced
back to the Old Babylonian period (c. 1800 BC), the emergence of financial management
as a key business activity is a far more recent development. During the 20th century,
financial management has evolved from a peripheral to a central aspect of corporate
life. This change has been brought about largely through the need to respond to the
changing economic climate.
With continuing industrialisation in the UK and much of Europe in the first quarter of the last century, the key financial issues centred on forming new businesses and
raising capital for expansion. Legal and descriptive consideration was given to the
types of security issued, company formations and mergers.
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Chapter 1 An overview of financial management
9
As the focus of business activity moved from growth to survival during the depression of the 1930s, finance evolved by focusing more on business liquidity, reorganisation and insolvency.
Successive Companies Acts, Accounting Standards and other regulations have been
designed to increase investors’ confidence in published financial statements and financial markets. However, the US accounting scandals in 2002, involving such giants as
Enron and Worldcom, have dented this confidence.
Recent years have seen the emergence of financial management as a major contributor to the analysis of investment and financing decisions. The subject continues to
respond to external economic and technical developments:
1 The move to floating exchange rates, high interest rates and inflation during the
1970s focused attention on interest rate and currency management, and the impact
of inflation on business decisions. For example, in September 1992, following
intense pressure by currency speculators, the UK government was forced to suspend its membership of the Exchange Rate Mechanism, leading to the devaluation
of sterling. New ways of coping with these uncertainties have been developed to
allow investors to hedge, or cover, such risks. It is argued that countries adopting
the euro as their currency will remove some of these uncertainties.
2 Successive waves of merger activity over the past forty years have increased our
understanding of valuation and takeover tactics. With governments committed to
freedom of markets and financial liberalisation, acquisitions, mega-mergers and
management buy-outs have become a regular part of business life.
3 Technological progress in communications has led to the globalisation of business.
The single European market has created a major financial market with generally
unrestricted capital movement. Modern computer technology not only makes globalisation of finance possible, but also brings complex financial calculations and
financial databases within easy reach of every manager.
4 Complexities in taxation and the enormous growth in new financial instruments for
raising money and managing risk have made some aspects of financial management
highly specialised. The collapse in 1995 of Barings, the highly respected merchant
bank, resulted from a lack of internal controls in the complex derivatives market.
5 Deregulation in the City is an attempt to make financial markets more efficient and
competitive. The full adoption of the euro in 2002 for most European countries has
reduced the risk and cost of doing business between such nations.
6 Greater awareness of the need to view all decision-making within a strategic framework is moving the focus away from purely technical to more strategic issues. For
example, a good deal of corporate restructuring has taken place, breaking down
large organisations into smaller, more strategically compatible, businesses.
1.6
THE FINANCE DEPARTMENT IN THE FIRM
The organisation structure for the finance department will vary with company size and
other factors. The board of directors is appointed by the shareholders of the company.
Virtually all business organisations of any size are limited liability companies, thereby
reducing the risk borne by shareholders and, for companies whose shares are listed on
a stock exchange, giving investors a ready market for disposal of their holdings or further investment.
The financial manager can help in the attainment of corporate objectives in the following ways:
1 Strategic investment and financing decisions. The financial manager must raise the
finance to fund growth and assist in the appraisal of key capital projects.
2 Dealing with the capital markets. The financial manager, as the intermediary between
the markets and the company, must develop good links with the company’s bankers
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10 Part I A framework for financial decisions
and other major financiers, and be aware of the appropriate sources of finance for
corporate requirements.
3 Managing exposure to risk. The finance manager should ensure that exposure to adverse
movements in interest and exchange rates is adequately managed. Various techniques
for hedging (a term for reducing exposure to risk) are available.
4 Forecasting, coordination and control. Virtually all important business decisions have
financial implications. The financial manager should assist in and, where appropriate, coordinate and control activities that have a significant impact on cash flow.
Self-assessment activity 1.2
What are the financial manager’s primary tasks?
(Answer in Appendix A at the back of the book)
1.7
THE FINANCIAL OBJECTIVE
For any company, there are likely to be a number of corporate goals, some of which
may, on occasions, conflict. In finance, we assume that the objective of the firm is to
maximise shareholder value. Put simply, this means that managers should create as
much wealth as possible for the shareholders. Given this objective, any financing or
investment decision expected to improve the value of the shareholders’ stake in the
firm is acceptable. You may be wondering why shareholder wealth maximisation is
preferred to profit maximisation. Quite apart from the problems associated with profit measurement, it ignores the timing and risks of the profit flows. As will be seen later,
value is heavily dependent on when costs and benefits arise and the uncertainty surrounding them.
The Quaker Oats Company was one of the first firms to adopt this goal:
Our objective is to maximise value for shareholders over the long term … Ultimately,
our goal is the goal of all professional investors – to maximise value by generating the
highest cash flow possible.
Earnings per share
Profit available for distribution
to shareholders divided by the
number of shares issued
However, many practising managers might take a different view of the goal of their
firm. In recent years, a wide variety of goals have been suggested, from the traditional goal of profit maximisation to goals relating to sales, employee welfare, manager
satisfaction, survival and the good of society. It has also been questioned whether
management attempts to maximise, by seeking optimal solutions, or to seek merely
satisfactory solutions.
Managers often seem to pursue a sales maximisation goal subject to a minimum
profit constraint. As long as a company matches the average rate of return for the
industry sector, the shareholders are likely to be content to stay with their investment.
Thus, once this level is attained, managers will be tempted to pursue other goals. As
sales levels are frequently employed as a basis for managerial salaries and status, managers may adopt goals that maximise sales subject to a minimum profit constraint.
A popular performance target is earnings per share (EPS). It focuses on the shareholder, rather than the company’s performance, by calculating the earnings (i.e. profits after tax) attributable to each equity share.
Other subsidiary targets may be employed, often more in the form of a constraint
ensuring that management does not threaten corporate survival in its pursuit of shareholder goals. Examples of such secondary goals which are sometimes employed
include targets for:
1 Profit retention. For example, ‘distributable profits must always be, say, at least three
times greater than dividends’.
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Chapter 1 An overview of financial management
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2 Borrowing levels. For example, ‘long-term borrowing should not exceed 50 per cent
of total capital employed’.
3 Profitability. For example, ‘return on capital employed should be at least 18 per cent’.
4 Non-financial goals. These take a variety of forms but basically recognise that shareholders are not the only group interested in the company’s success. Other stakeholders include trade creditors, banks, employees, the government and management.
Each stakeholder group will measure corporate performance in a slightly different
way. It is therefore to be expected that the targets and constraints discussed above
will, from time to time, conflict with the overriding goal of shareholder value, and
management must seek to manage these conflicts.
The financial manager has the specific task of advising management on the financial
implications of the firm’s plans and activities. The shareholder wealth objective should
underlie all such advice, although the chief executive may sometimes allow non-financial
considerations to take precedence over financial ones. It is not possible to translate this
objective directly to the public sector or not-for-profit organisations. However, in seeking
to create wealth in such organisations, the ‘value for money’ goal perhaps comes close.
Self-assessment activity 1.3
The past ten years have seen a much greater emphasis on investor-related goals, such as
earnings per share and shareholder wealth. Why do you think this has arisen?
(Answer in Appendix A at the back of the book)
1.8
THE AGENCY PROBLEM
Principal–agent
The agent, such as board of
directors, is expected to act in
the best interests of the principal (e.g. the shareholder)
Potential conflict arises where ownership is separated from management. The ownership
of most larger companies is widely spread, while the day-to-day control of the business
rests in the hands of a few managers who usually own a relatively small proportion of the
total shares issued. This can give rise to what is termed managerialism – self-serving
behaviour by managers at the shareholders’ expense. Examples of managerialism include
pursuing more perquisites (splendid offices and company cars, etc.) and adopting lowrisk survival strategies and ‘satisficing’ behaviour. This conflict has been explored by
Jensen and Meckling (1976), who developed a theory of the firm under agency arrangements. Managers are, in effect, agents for the shareholders and are required to act in their
best interests. However, they have operational control of the business and the shareholders receive little information on whether the managers are acting in their best interests.
A company can be viewed as simply a set of contracts, the most important of
which is the contract between the firm and its shareholders. This contract describes
the principal–agent relationship, where the shareholders are the principals and the
management team the agents. An efficient agency contract allows full delegation of
decision-making authority over use of invested capital to management without the
risk of that authority being abused. However, left to themselves, managers cannot be
expected to act in the shareholders’ best interests, but require appropriate incentives
and controls to do so. Agency costs are the difference between the return expected
from an efficient agency contract and the actual return, given that managers may act
more in their own interests than the interests of shareholders.
Self-assessment activity 1.4
Identify some potential agency problems that may arise between shareholders and managers.
(Answer in Appendix A at the back of the book)
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12 Part I A framework for financial decisions
1.9
MANAGING THE AGENCY PROBLEM
To attempt to deal with such agency problems, various incentives and controls have
been recommended, all of which incur costs. Incentives frequently take the form of
bonuses tied to profits (profit-related pay) and share options as part of a remuneration
package scheme.
Managerial incentives: Blanco plc
Relating managers’ compensation to achievement of owner-oriented targets is an obvious way
to bring the interests of managers and shareholders closer together. A group of major institutional shareholders of Blanco plc has expressed concern to the chief executive that management decisions do not appear to be fully in line with shareholder requirements. They suggest
that a new remuneration package is introduced to help solve the problem. Such packages have
increasingly been introduced to encourage managers to take decisions that are consistent with
the objectives of the shareholders.
The main factors to be considered by Blanco plc might include the following:
1 Linking management compensation to changes in shareholder wealth, where possible
reflecting managers’ contributions.
2 Rewarding managerial efficiency, not managerial luck.
3 Matching the time horizon for managers’ decisions to that of shareholders. Many managers
seek to maximise short-term profits rather than long-term shareholder wealth.
4 Making the scheme easy to monitor, inexpensive to operate, clearly defined and incapable
of managerial manipulation. Poorly devised schemes have sometimes ‘backfired’, giving senior managers huge bonuses.
Two performance-based incentive schemes that Blanco plc might consider are rewarding
managers with shares or with share options.
1 Long-term incentive plans (LTIPs). Such schemes typically incentivise performance over a
period of three or more years, with the manager receiving the award at the end of the period. Shares are allotted to managers on attaining performance targets. Commonly employed
performance measures are growth in earnings per share, return on equity and return on
assets. Managers are allocated a certain number of shares to be received on attaining prescribed targets. While this incentive scheme offers managers greater control, the performance measures may not be entirely consistent with shareholder goals. For example, adoption
of return on assets as a measure, which is based on book values, can inhibit investment in
wealth-creating projects with heavy depreciation charges in early years.
2 Executive share option schemes. These are long-term compensation arrangements that permit managers to buy shares at a given price (generally today’s) at some future date (generally 3–10 years). Subject to certain provisos and tax rules, a share option scheme usually
entitles managers to acquire a fixed number of shares over a fixed period of time for a fixed
price. The shares need not be paid for until the option is exercised – normally 3–10 years
after the granting of the option. For example, a manager may be granted 20,000 share
options. She can purchase these shares at any time over the next three years at £1 a share.
If she decides to exercise her option when the share price has risen to £4, she would have
gained £60,000 (i.e. buying 20,000 shares at £1, now worth £80,000).
Share options only have value when the actual share price exceeds the option price;
managers are thereby encouraged to pursue policies that enhance long-term wealthcreation. Most large UK companies now operate share option schemes, which are
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Chapter 1 An overview of financial management
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spreading to managers well below board level. The figure is far higher for companies
recently coming to the stock market: virtually all of them have executive share option
schemes, and many of these operate an all-employee scheme. However, a major problem with these approaches is that general stock market movements, due mainly to
macroeconomic events, are sometimes so large as to dwarf the efforts of managers. No
matter how hard a management team seeks to make wealth-creating decisions, the
effects on share price in a given year may be undetectable if general market movements
are downward. A good incentive scheme gives managers a large degree of control over
achieving targets. Chief executives in a number of large companies have recently come
under fire for their ‘outrageously high’ pay resulting from such schemes.
Executive compensation schemes, such as those outlined above, are imperfect, but
useful, mechanisms for retaining able managers and encouraging them to pursue
goals that promote shareholder value.
Another way of attempting to minimise the agency problem is by setting up and
monitoring managers’ behaviour. Examples of these include:
1 audited accounts of the company;
2 management audits and additional reporting requirements; and
3 restrictive covenants imposed by lenders, such as ceilings on the dividend payable
on the maximum borrowings.
To what extent does the agency problem invalidate the goal of maximising the value
of the firm? In an efficient, highly competitive stock market, the share price is a ‘fair’
reflection of investors’ perceptions of the company’s expected future performance. So
agency problems in a large publicly quoted company will, before long, be reflected in
a lower than expected share price. This could lead to an internal response – the shareholders replacing the board of directors with others more committed to their goals – or
an external response – the company being acquired by a better-performing company
where shareholder interests are pursued more vigorously.
1.10
SOCIAL RESPONSIBILITY AND SHAREHOLDER WEALTH
Is the shareholder wealth maximisation objective consistent with concern for social
responsibility? In most cases it is. As far back as 1776, Adam Smith recognised that, in
a market-based economy, the wider needs of society are met by individuals pursuing
their own interests: ‘It is not from the benevolence of the butcher, the brewer, or the
baker, that we expect our dinner, but from their regard to their own interest.’ The needs
of customers and the goals of businesses are matched by the ‘invisible hand’ of the free
market mechanism.
Of course, the market mechanism cannot differentiate between ‘right’ and ‘wrong’.
Addictive drugs and other socially undesirable products will be made available as
long as customers are willing to pay for them. Legislation may work, but often it simply creates illegal markets in which prices are much higher than before legislation.
Other products have side-effects adversely affecting individuals other than the consumers, e.g. passive smoking and car exhaust emissions.
There will always be individuals in business seeking short-term gains from unethical activities. But, for the vast majority of firms, such activity is counterproductive in
the longer term. Shareholder wealth rests on companies building long-term relationships with suppliers, customers and employees, and promoting a reputation for honesty, financial integrity and corporate social responsibility. After all, a major company’s
most important asset is its good name.
Not all large businesses are dominated by shareholder wealth goals. The John
Lewis Partnership, which operates department stores and Waitrose supermarkets, is a
partnership with its staff electing half the board. The Partnership’s ultimate aim, as
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14 Part I A framework for financial decisions
described in its constitution, ‘shall be the happiness in every way of all its members’.
The Partnership rule book makes it clear, however, that pursuit of happiness shall not
be at the expense of business efficiency.
Some authors have questioned the strong emphasis on shareholder goals, preferring shareholders to be regarded more like financial guardians, keeping a watchful eye
on business and not selling out for short-term gains. Certainly, Japanese companies
seem to place less emphasis on shareholder returns than UK or US companies, typically paying out far less in dividends than UK companies.
Environmental concerns have in recent years become an important consideration
for the boards of large companies, including the source of supplies, such as timber
and paper from ‘managed forests’. Investors are also becoming more socially aware
and many are channelling their funds into companies that employ environmentally and socially responsible practices.
1.11
THE CORPORATE GOVERNANCE DEBATE
In recent years, there has been considerable concern in the UK about standards of corporate governance, the system by which companies are directed and controlled. While,
in company law, directors are obliged to act in the best interests of shareholders, there
have been many instances of boardroom behaviour difficult to reconcile with this ideal.
There have been numerous examples of spectacular collapses of companies, often the
result of excessive debt financing in order to finance ill-advised takeovers, and sometimes
laced with fraud. Many companies have been criticised for the generosity with which
they reward their leading executives. The procedures for remunerating executives have
been less than transparent, and many compensation schemes involve payment by results
in one direction alone. Many chief executives have been criticised for receiving pay
increases several times greater than the increases awarded to less exalted staff.
In the train of these corporate collapses and scandals, a number of committees have
reported on the accountability of the board of directors to their stakeholders and risk
management procedures.
The Combined Code on Corporate Governance, introduced in 2003, applies to all listed companies. Its main requirements for financial management are summarised below.
1 Directors and the board
■ There should be a clear division of responsibilities between the running of the
board (chairman) and the executive responsibility for the running of the business
(chief executive).
■ The board should include a balance of executive and independent nonexecutive
directors.
■ It should be supplied in a timely manner with information in a form and quality
appropriate to enable it to discharge its duties.
2 Directors’ remuneration
■ Levels of remuneration should be sufficient to attract, retain and motivate directors, but should not be more than is necessary for the purpose.
■ No director should be involved in deciding his/her remuneration.
■ The performance-related elements of remuneration should form a significant proportion of the total remuneration package of executive directors and be designed
to align their interests with those of shareholders.
3 Accountability and audit
■ The board should present a balanced and understandable assessment of the company’s position and prospects.
■ The directors should report that the business is a going concern, with supporting
assumptions or qualifications as necessary.
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Chapter 1 An overview of financial management
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The board should maintain a sound system of internal control to safeguard shareholders’ investment and the company’s assets.
■ The board should establish an audit committee to monitor the integrity of financial statements.
4 Relations with shareholders
■ The board should maintain a satisfactory dialogue with shareholders and keep in
touch with shareholder opinion in whatever ways are practical and efficient.
■ The board should use the AGM to communicate to investors and encourage
participation.
■
Corporate governance is an important issue throughout the world and most countries
have developed a code or recommendations. (A website for the relevant country codes
is given at the end of this chapter.) In the US, for example, the Sarbanes-Oxley Act of
2002 is intended to protect investors by improving the accuracy and reliability of corporate reporting.
The main reservations centre on the issues of compliance and enforcement. These
changes in the rules and responsibilities of directors and auditors are non-statutory. The
Stock Exchange will not withdraw the listings of companies that fail to comply, although it
hopes that any adverse publicity will whip offenders into line. This lack of ‘teeth’ has raised
suspicions that determined wrongdoers can still exert their influence on weak boards of
directors, to the detriment of the relatively ill-informed private investor in particular.
A manager’s real responsibility
Businesses fail. As Joseph Schumpeter, the great
Austrian economist, pointed out almost a century
ago, such ‘creative destruction’ lies at the heart of
the market economy’s dynamism. Coming at the
end of an era of rapid growth, swift technological
change and widespread euphoria, a big corporate
failure, such as Enron’s, cannot be that surprising.
There could be many more. Yet the Enron case also
sheds intriguing light on conflicts of interest inherent in corporate capitalism.
The corporation is a wonderful institution. But
it contains inherent drawbacks, at the core of
which are conflicts of interest. Control over the
company’s resources is vested in the hands of top
managers who may rationally pursue their interests at the expense of all others. Economists call
this the ‘principal–agent’ problem. In the modern
economy, where shares are held by fund managers, there is not just one set of principal–agent
relations but a long chain of them.
The principal–agent problem is exacerbated by
two others: asymmetric information and obstacles
to collective action. Corporate managers know more
about what is going on in the business than anybody else and have an interest in keeping at least
some of this information to themselves. Equally,
dispersed shareholders have a weak incentive to
act, because they would share the gains with others
but bear much of the cost themselves.
The upshot is the chronic vulnerability of the
corporation to managerial incompetence, self-seeking, deceit or downright malfeasance. In practice,
there are five (interconnected) ways of reducing
these risks. The first is market discipline, since failure will ultimately find managers out. The second is
internal checks, with independent directors or
requirements for voting by institutional shareholders. The third is regulation covering the composition of boards, structure of businesses and reporting requirements. The fourth is transparency,
including accounting standards and independent
audits. The last is simply values of honest dealing.
Economists are very uncomfortable with the
notion of morality. Yet it seems to have rather a
clear meaning in the business context. It consists
of acting honestly even when the opposite may be
to one’s advantage. Such morality is essential for
all trustee relationships. Without it, costs of supervision and control become exorbitant. At the limit,
a range of transactions and long-term relationships becomes impossible and society remains
impoverished. Corporate managers are trustees. So
are fund managers. The more they view themselves (and are viewed) as such, the less they are
Continued
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16 Part I A framework for financial decisions
likely to exploit opportunities created by the conflicts of interest within the business. What has all
this to do with Enron? The answer is that the
checks failed. The conflicts of interest of those
responsible for transparency (the auditors) were
huge and rules governing accounting proved inadequate. Because information was insufficient, the
company was able to pursue its bets well beyond
a sensible limit. The vast personal wealth available
to top management also created big incentives for
such behaviour.
None of this is unique to Enron. In what will
surely come to be called the US bubble era, top
1.12
managers were allowed to do many things that
made little sense for anybody but themselves.
Lavish share options that failed to align their interests with those of shareholders were just one
example. The response will be to tighten up on regulation. Some of this is necessary, particularly over
the role of auditors and the probity of accounts.
Yet care must be taken. Any system guaranteed to
prevent bankruptcies would damage the risk-taking
essential to economic dynamism.
Source: Based on Martin Woolf, Financial Times,
30 January 2002, p. 19.
THE RISK DIMENSION
Expected Return
Some financial decisions incur very little risk (e.g. investing in government stocks, since
the interest is known); others may carry far more risk (e.g. investing in shares). Risk and
expected return tend to be related: the greater the perceived risk, the greater the return
required by investors. This is seen in Figure 1.3.
When the finance manager of a company seeks to raise funds, potential investors
take a view on the risk related to the intended use of the funds. This can best be measured in terms of a risk premium above the risk-free rate (Rf) obtainable from, say, government stocks to compensate investors for taking risk. The capital market offers a host
of investment opportunities for private and corporate investors, but in all cases there
exists a clear relationship between the perceived degree of risk involved and the expected return. For example, Rf in Figure 1.3 represents the return on three-month Treasury
Bills; point A represents a long-term fixed interest corporate bond; point B, a portfolio
of ordinary shares in major listed companies; and point C, a more speculative investment, such as non-quoted shares. Studies indicate that the long-term average return on
an investment portfolio consisting of the market index (e.g. the FTSE-100) is up to 6 percentage points higher than that from holding risk-free government securities.
One task of the financial manager is to raise funds in the capital markets at a cost consistent with the perceived risk, and to invest such funds in wealth-creating opportunities
in the business. Here it is quite possible – because of a firm’s competitive advantage, or
possession of superior brand names – to make highly profitable capital projects with relatively little risk (see D in diagram). It is also possible to find the reverse, such as project E.
Speculative
Investments
D
Equities
B
C
Risk
Premium
A
Corporate Bonds
Rf
E
Risk-free
Return
Figure 1.3
The risk–return
trade-off
0
Risk
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Chapter 1 An overview of financial management
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If the goal is to deliver cash flows to shareholders at rates above their cost of capital, managers should seek to invest in projects, such as D, that offer returns better than those
obtainable on the capital market for the same degree of risk (A in the diagram).
1.13
THE STRATEGIC DIMENSION
To enhance shareholder value, managers could adopt a wide range of strategies. Strategic
management may be defined as a systematic approach to positioning the business in relation to its environment to ensure continued success and offer security from surprises. No
approach can guarantee continuous success and total security, but an integrated approach
to strategy formulation, involving all levels of management, can go some way.
Strategy can be developed at three levels:
1 Corporate strategy is concerned with the broad issues, such as the types of business
the company should be in. Strategic finance has an important role to play here. For
example, the decision to enter or exit from a business – whether through corporate
acquisitions, organic growth, divestment or buy-outs – requires sound financial
analysis. Similarly, the appropriate capital structure and dividend policy form part
of strategic development at the corporate level.
2 Business or competitive strategy is concerned with how strategic business units compete
in particular markets. Business strategies are formulated which influence the allocation of resources to these units. This allocation may be based on the attractiveness of
the markets in which business units operate and the firm’s competitive strengths.
3 Operational strategy is concerned with how functional levels contribute to corporate and
business strategies. For example, the finance function may formulate strategies to
achieve a new dividend policy identified at the corporate strategy level. Similarly, a foreign currency exposure strategy may be developed to reduce the risk of loss through
currency movements. A typical strategic planning process is shown in Figure 1.4.
Business
mission
Environmental scan
at business level
Internal scrutiny
at business level
Formulation of
business strategy
Definition and evaluation
of specific action programmes
Resource allocation
Figure 1.4
Main elements in
strategic planning
Budgeting and
performance measurement
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18 Part I A framework for financial decisions
■
Strategic planning and value creation
The importance of competitive forces in determining shareholder wealth cannot be
overestimated. They largely determine the price at which goods and services can be
sold, the quantities sold, the cost of production, the level of required investment and
the risks inherent in the business.
However, individual companies can develop strategies leading to long-term financial performance well above the industry average. A study of the consequences of
business strategies on financial performance concluded that market share, quality,
capacity utilisation and capital investment strategies had the greatest impact on shareholder wealth (Gale and Swire, 1988).
Figure 1.5 illustrates the main factors influencing the value of the firm. In any
industry, all firms will be subject to much the same underlying economic conditions.
Rates of inflation, interest and taxation and competitive forces in the industry will
affect all businesses, although not necessarily to the same degree. The firm will develop corporate, business and operating strategies to exploit economic opportunities
and to create sustainable competitive advantage. We are mainly concerned with those
strategies affecting investment, financing and dividends. Operating and investment
decisions create cash flows for the business, while financing decisions influence the
cost of capital. The value of the firm depends upon the cash flows generated from
business operations – their size, timing and riskiness – and the firm’s cost of capital.
Depending on the success of the firm’s strategies and decisions, the value of the firm
will increase or shrink.
While, in practice, some decisions appear to lack any rational process, most approaches to decisions of a financial nature have five common elements:
1 Clearly defined goals. It is particularly noticeable how, in recent years, corporate managements have realised the importance of defining and communicating their
declared mission and goals, some more quantifiable than others, and some more
relevant to financing decisions. For Cadbury Schweppes plc the goal is growth in
shareholder value.
2 Identifying courses of action to achieve these objectives. This requires the development
of business strategies from which individual decisions emanate. Cadbury
Schweppes identifies focusing on growth markets, developing brands, innovation
and acquisitions as key approaches to goal attainment.
External
economic
conditions
Operating and
investment decisions
Management
strategies and
policies
Figure 1.5
Factors influencing the
value of the firm
Cash
flow
Value
of
firm
Financing
decisions
Cost of
capital
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Chapter 1 An overview of financial management
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The search for new investment and financing opportunities for any organisation
is far better focused and cost-effective when viewed within well-defined financial
objectives and strategies. Most decisions have more than one possible solution. For
instance, the requirement for an additional source of finance to fund a new product launch can be satisfied by a multitude of possible financial options.
3 Assembling information relevant to the decision. The financial manager must be able to
identify what information is relevant to the decision and what is not. Data gathering can be costly, but good, reliable information greatly facilitates decision analysis
and confidence in the decision outcome.
4 Evaluation. Analysing and interpreting assembled information lies at the heart of
financial analysis. A large part of this book is devoted to techniques of appraising
financial decisions.
5 Monitoring the effects of the decision taken. However sophisticated a firm’s financial
planning system, there is no real substitute for experience. Feedback on the performance of past decisions provides vital information on the reliability of data gathered, the efficacy of the method employed in decision appraisal and the judgement
of decision-makers.
Goals and strategies in Cadbury Schweppes
Cadbury Schweppes’ objective is growth in shareholder value. The strategy by which we will
achieve this objective is:
■
■
■
■
Focusing on our core growth of beverages and confectionery
Developing robust, sustainable market positions which are built on a platform of strong
brands with supported franchises
Expanding our market share through innovation in products, packaging and route to market
where economically profitable
Enhancing our market positions by acquisitions or disposals.
Managing for Value is the process which supports the achievement of our strategy.
Source: Annual Report, 2000.
Self-assessment Activity 1.5
Compare Cadbury’s objectives and strategies with those of Tomkins provided at the start
of the chapter.
1 What do they have in common and how do they differ?
2 What issues discussed in the chapter do they focus upon?
Throughout this book, we shall attempt to allow for practical, real-world considerations when considering appropriate financial policy decisions. However, we hope
that a clearer understanding of the concepts, together with an awareness of the degree
of realism in their underlying assumptions, will enable the reader to make sound and
successful investment and financial decisions in practice.
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20 Part I A framework for financial decisions
The following advertisement recently appeared in a major newspaper:
Shareholder value
We are seeking a manager to join a small management team to develop concepts in our
organisation. This is an important role with exposure to all levels of management, both
centrally and within our business units.
You will communicate shareholder value concepts to decision makers and assist in
piloting the implementation of a value based perspective.
A highly motivated qualified accountant or MBA, you should have at least 3 years’ post
qualification experience – what’s more important will be an impressive track record.
With excellent communication and influencing skills, you should have a high degree of
numeracy, be pragmatic and open to new ideas and concepts.
You will preferably have an excellent knowledge of shareholder value concepts in a corporate environment or working as a consultant.
Having read this chapter the reader should have a clearer idea of the shareholder
value concepts involved (and how to obtain jobs like this!).
SUMMARY
This chapter has provided an overview of strategic financial management and the critical role it plays in corporate survival and success. We have examined how financial
management has evolved over the years, its main functions and objectives. The chapter concludes by introducing readers to the underlying principles of finance.
Key points
■
It is the task of the financial manager to plan, raise and use funds in an efficient
manner to achieve corporate financial objectives. This implies (1) involvement in
investment and financing decisions, (2) dealing with the financial markets, and
(3) forecasting, coordinating and controlling cash flows.
■
Cash is the lifeblood of any business. Financial management is concerned with cash
generation and control.
■
Financial management evolved during the last century, largely in response to economic and other external events (e.g. inflation and technological developments),
making globalisation of finance a reality and the need to concentrate on more strategic issues essential.
■
The distinction should be drawn between accounting – the mere provision of relevant financial information for internal and external users – and financial management – the utilisation of financial and other data to assist financial decision-making.
■
In finance, we assume that the primary corporate goal is to maximise value for the
shareholders.
■
The agency problem – managers pursuing actions not totally consistent with shareholders’ interests – can be reduced both by managerial incentive schemes and also
by closer monitoring of their actions.
■
Investors require compensation for taking risks in the form of enhanced potential
returns.
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Chapter 1 An overview of financial management
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■
Most of the assumptions underlying pure finance theory are not particularly realistic.
In practice, market and other imperfections must also be considered in practical
financial decision-making.
■
Financial management has an essential role in strategic development and implementation at strategic, business and operational levels. Competitive forces, together
with business strategy, influence the value drivers that impact on shareholder value.
Further reading
Students should get into the habit of reading the Financial Times and relevant pages of The
Economist and Investors Chronicle.
For a fuller discussion on managerial compensation, see Lambert and Larcker (1985). Jensen and
Meckling (1976) and Fama (1980) provide the best article on agency costs while Brickley et al.
(1994) give a useful insight into organisational ethics and social responsibility. Grinyer (1986) provides an alternative to the shareholder wealth goal while Doyle (1994) argues for a ‘stakeholder’
approach to goal setting. On the other hand, Koller et al. (2005) argue that shareholder wealth
creation is good for all stakeholders, productivity and employment. Details on these and other
references are provided at the end of the book.
Useful websites
Financial Times: www.FT.com
Guardian: www.guardian.co.uk/money
The Economist: www.economist.com
Corporate governance codes in other countries: www.ecgi.org/codes/all_codes
Companies House: www.companieshouse.gov.uk
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22 Part I A framework for financial decisions
QUESTIONS
Questions with a coloured number have solutions in Appendix B on page 691.
1 Why is the goal of maximising owners’ wealth helpful in analysing capital investment decisions? What other
goals should also be considered?
2 Go4it plc is a young dynamic company which became listed on the stock market three years ago. Its management is very keen to do all it can to maximise shareholder value and, for this reason, has been advised to
pursue the goal of maximising earnings per share. Do you agree?
3 (a) ‘Managers and owners of businesses may not have the same objectives.’ Explain this statement, illustrating your answer with examples of possible conflicts of interest.
(b) In what respects can it be argued that companies need to exercise corporate social responsibility?
(c) Explain the meaning of the term ‘Value for Money’ in relation to the management of publicly owned
services/utilities.
(ACCA)
4 Discuss the importance and limitations of ESOPs (executive share option plans) to the achievement of goal
congruence within an organisation.
(ACCA)
5 (a) A group of major shareholders of Zedo plc wishes to introduce a new remuneration scheme for the
company’s senior management. Explain why such schemes might be important to the shareholders. What
factors should shareholders consider when devising such schemes?
(b) Eventually a short-list of three possible schemes is agreed. All pay the same basic salary plus:
(i) A bonus based upon at least a minimum pre-tax profit being achieved.
(ii) A bonus based upon turnover growth.
(iii) A share option scheme.
Briefly discuss the advantages and disadvantages of each of these three schemes.
(ACCA)
6 The primary financial objective of companies is usually said to be the maximisation of shareholders’ wealth.
Discuss whether this objective is realistic in a world where corporate ownership and control are often separate, and environmental and social factors are increasingly affecting business decisions.
7 The main principles of financial management may be applied to most organisations. However, the role of the
financial manager may be affected by the type of organisation in which he or she works.
Required
Describe the key characteristics of the financial management function and the role of the financial manager in
each of the following types of organisation.
(a)
(b)
(c)
(d)
(e)
(f)
Quoted high-growth company
Quoted low-growth company
Unquoted company aiming for a stock exchange listing
Small family-owned business
Non-profit-making organisation, for example a charity
Public sector, for example a government department
(CIMA)
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Chapter 1 An overview of financial management
8 (a) The Cleevemoor Water Authority was privatised in 2000, to become Northern Water plc (NW). Apart
from political considerations, a major motive for the privatisation was to allow access for NW to private
sector supplies of finance. During the 1990s, central government controls on capital expenditure had
resulted in relatively low levels of investment, so that considerable investment was required to enable the
company to meet more stringent water quality regulations. When privatised, it was valued by the merchant bankers advising on the issue at £100 million and was floated in the form of 100 million ordinary
shares (par value 50p), sold fully paid for £1 each. The shares reached a premium of 60 per cent on the
first day of stock market trading.
Required
In what ways might you expect the objectives of an organisation like Cleevemoor/NW to alter following
transfer from public to private ownership?
(b) Selected biannual data from NW’s accounts are provided below relating to its first six years of operation
as a private sector concern. Also shown, for comparison, are the pro forma data as included in the privatisation documents. The pro forma accounts are notional accounts prepared to show the operating and
financial performance of the company in its last year under public ownership as if it had applied private
sector accounting conventions. They also incorporate a dividend payment based on the dividend policy
declared in the prospectus.
The activities of privatised utilities are scrutinised by a regulatory body which restricts the extent to
which prices can be increased. The demand for water in the area served by NW has risen over time at a
steady 2 per cent per annum, largely reflecting demographic trends.
Required
Using the data provided, assess the extent to which NW has met the interests of the following groups of
stakeholders in its first six years as a privatised enterprise.
Key financial and operating data for year ending 31 December (£m)
Turnover
Operating profit
Taxation
Profit after tax
Dividends
Total assets
Capital expenditure
Wage bill
Directors’ emoluments
Employees (number)
P:E ratio (average)
Retail Price Index
2000
(pro forma)
2002
(actual)
2004
(actual)
2006
(actual)
450
26
5
21
7
100
20
100
0.8
12,000
–
100
480
35
6
29
10
119
30
98
2.0
11,800
7.0
102
540
55
8
47
15
151
60
90
2.3
10,500
8.0
105
620
75
10
65
20
191
75
86
3.0
10,000
7.5
109
If relevant, suggest what other data would be helpful in forming a more balanced view.
(i) shareholders
(ii) consumers
(iii) the workforce
(iv) the government, through NW’s contribution to the achievement of macroeconomic policies of price
stability and economic growth.
(ACCA)
Practical assignment
Examine the annual report for a well-known company, particularly the chairman’s statement. Are the corporate
goals clearly specified? What specific references are made to financial management? What does it say about
corporate governance and risk management?
23
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2
The financial environment
City fumes over Marconi share suspension
On July 4 2001, investors in the City of London were
seething over Marconi’s decision, approved by the
London Stock Exchange and Financial Services
Authority, to suspend trading in its shares ahead of its
profit warning.
Having signed a deal to sell its medical systems
business to Philips Electronics for $1.1 billion during
the night, both companies felt obliged to put out a
statement next morning. However, Marconi and its
brokers feared it would be problematic to allow
investors to trade on the basis of a successful disposal at the same time as the company was preparing to
issue a profits warning only hours later. When trading
in the shares resumed after the profit warning,
Marconi’s shares tumbled by 57 per cent from 245p
to a 20-year low of 104p, valuing the company at
£2.91 billion – less than 10 per cent of its worth ten
months earlier.
Angry shareholders called for top management
changes in the wake of the severe profit warning
when, just a month before, management were issuing
bullish statements despite evidence of a global slowdown in the sector.
Efficient financial markets imply that investors are
informed on all price-sensitive matters. So what does
this case tell us about market efficiency, and what are
the implications for corporate finance?
Source: Based on Financial Times, 5–7 July 2001
Learning objectives
By the end of this chapter, the reader should understand the nature of financial markets and the
main players within them. Particular focus is placed on the following topics:
■
The functions of financial markets.
■
The operation of the Stock Exchange.
■
The extent to which capital markets are efficient.
■
How taxation affects corporate finance.
Enhanced ability to read financial statements and the financial pages in a newspaper should also
be achieved.
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Chapter 2 The financial environment
2.1
25
INTRODUCTION
The corporate financial manager has the important task of ensuring that there are
sufficient funds available to meet all the likely needs of the business. To do this properly, he or she requires a clear grasp both of the future financial requirements of the
business and of the workings of the financial markets. This chapter provides an
overview of these markets, and the major institutions within them, paying particular
attention to the Stock Exchange.
2.2
FINANCIAL MARKETS
financial market
Any market in which financial
assets and liabilities are traded
money market
The market for short-term
money, broadly speaking for
repayment within about a year
securities/capital market
The market for long-term
finance
spot
The spot, or cash market, is
where transactions are settled
immediately
forward
The forward market is where
contracts are made for future
settlement at a price specified
now
derivatives
Securities that are traded separately from the assets from
which they are derived
future
A tradable contract to buy or
sell a specified amount of an
asset at a specified price at a
specified future date
option
The right but not the obligation
to buy or sell a particular asset
A financial market is any mechanism for trading financial assets or securities.
Frequently, there is no physical market-place, transactions being conducted via telephone or computer. London is widely regarded as the pre-eminent European financial
centre and certainly is the largest by volume of dealing. Its main financial markets are
as follows:
1 The money market channels wholesale funds, usually for less than one year, from
lenders to borrowers. The market is largely dominated by the major banks and
other financial institutions, but local government and large companies also use it for
short-term lending and borrowing purposes.
2 The securities or capital market deals with long-dated securities such as shares and
loan stock. The London Stock Exchange is the best-known institution in the capital
market, but there are other important markets, such as the bond market (for longdated government and corporate borrowing) and the Eurobond market.
3 The foreign exchange market is a market for buying and selling one currency
against another. Deals are either on a spot basis (for immediate delivery) or on a
forward basis (for future delivery).
4 The London International Financial Futures and Options Exchange (LIFFE)
www.liffe.com provides various means of hedging (i.e. protecting) or speculating
against movements in currencies and interest rates. These are called derivatives
because they are derived from the underlying security. A future is an agreement to
buy or sell an asset (e.g. foreign currency, shares etc.) at an agreed price at some
future date. An option is the right, but not the obligation, to buy or sell such assets
at an agreed price at, or within, an agreed time period. LIFFE is now part of
Euronext.liffe after it was taken over in 2001 by Euronext, the operator of the linked
Amsterdam, Brussels and Paris stock exchanges. As a result, their derivatives trading, along with that of the Lisbon exchange, have been brought together into one
integrated market, another reflection of the ever-increasing globalisation of financial markets.
The financial markets provide mechanisms through which the corporate financial
manager has access to a wide range of sources of finance and instruments.
Capital markets function in two important ways:
1 Primary market – providing new capital for business and other activities, usually in
the form of share issues to new or existing shareholders (equity), or loans.
2 Secondary market – trading existing securities, thus enabling share or bond holders
to dispose of their holdings when they wish. An active secondary market is a necessary condition for an effective primary market, as no investor wants to feel
‘locked in’ to an investment that cannot be realised when desired.
Imagine what business life would be like if these capital markets were not available
to companies. New businesses could start up only if the owners had sufficient personal wealth to fund the initial capital investment; existing businesses could develop
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26 Part I A framework for financial decisions
financial intermediaries
Institutions that channel funds
from savers and depositors
with cash surpluses to people
and organisations with cash
shortages
only through re-investing profits generated; and investors could not easily dispose of
their shareholdings. In many parts of the world where financial markets are embryonic or even non-existent, this is exactly what does happen. The development of a strong
and healthy economy rests very largely on efficient, well-developed financial markets.
Financial markets promote savings and investment by providing mechanisms
whereby the financial requirements of lenders (suppliers of funds) and borrowers
(users of funds) can be met. Figure 2.1 shows in simple terms how businesses finance
their operations.
Financial institutions (e.g. pension funds, insurance companies, banks, building
societies, unit trusts and specialist investment institutions) act as financial intermediaries, collecting funds from savers to lend to their corporate and other customers
through the money and capital markets, or directly through loans, leasing and other
forms of financing.
Businesses are major users of these funds. The financial manager raises cash by selling claims to the company’s existing or future assets in financial markets (e.g. by issuing shares, debentures or Bills of Exchange) or borrowing from financial institutions.
The cash is then used to acquire fixed and current assets. If those investments are successful, they will generate positive cash flows from business operations. This cash surplus is used to service existing financial obligations in the form of dividends, interest
etc., and to make repayments. Any residue is re-invested in the business to replace
existing assets or to expand operations.
We focus in this chapter on the financial institutions and financial markets shown
in Figure 2.1.
Suppliers of funds
Businesses
Individuals
Government
Direct
investment
Deposits and
investment
Investment
Financial markets
Money market
Capital market
Exchanges
Over-the-counter
Real investments
Land
Buildings
Plant
Stock
Debtors
Loans, overdrafts,
mortgages, venture capital,
leasing etc.
New issues,
bills and acceptances
Figure 2.1
Financial markets,
institutions, suppliers
and users
Financial institutions
Banks
Pension funds
Insurance companies
Building societies
Finance companies
Users of funds
Businesses
Individuals
Government
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Chapter 2 The financial environment
■
27
Financial institutions provide essential services
The needs of lenders and borrowers rarely match. Hence, there is an important role for
financial intermediaries, such as banks, if the financial markets are to operate efficiently. Financial intermediaries perform the following functions:
1 Re-packaging, or pooling, finance: gathering small amounts of savings from a large number of individuals and re-packaging them into larger bundles for lending to businesses. The banks have an important role here.
2 Risk reduction: placing small sums from numerous individuals in large, well-diversified
investment portfolios, such as unit trusts.
3 Liquidity transformation: bringing together short-term savers and long-term borrowers (e.g. building societies and banks). Borrowing ‘short’ and lending ‘long’ is
acceptable only where relatively few savers will want to withdraw funds at any
given time. The history of banking failures in the USA shows that this is not always
the case.
4 Cost reduction: minimising transaction costs by providing convenient and relatively
inexpensive services for linking small savers to larger borrowers.
5 Financial advice: providing advisory and other services for both lender and borrower.
2.3
THE FINANCIAL SERVICES SECTOR
The financial services sector can be divided into three groups: institutions engaged in
(1) deposit-taking, (2) contractual savings and (3) other investment funds.
■
Deposit-taking institutions
clearing banks
Banks (mainly the High Street
banks) that are members of the
Central Clearing House that
arranges the mutual offsetting of
cheques drawn on different banks
retail banking
Retail banks accept deposits
from the general public who
can draw on these accounts by
cheque (or ATM), and lend to
other people and organisations
seeking funds
accepting houses
Accepting Houses are specialist
institutions that discount or
‘’accept’’ Bills of Exchange, especially short-term government
securities (see Chapter 15)
discount houses
Discount Houses bid for issues
of short-term government securities at a discount and either
hold them to maturity, or sell
them on in the money market
merchant banks
Merchant banks are wholesale
banks that arrange specialist
financial services like mergers
and acquisition funding, finance
of international trade fund
management
Clearing banks have three important roles: they manage nationwide networks of High
Street branches and on-line facilities; they operate a national payments system by clearing cheques and by receiving and paying out notes and coins; and they accept deposits
in varying amounts from a wide range of customers. Hence, these operations are often
called retail banking. As well as being the dominant force in retail banking, the clearing
banks have diversified into wholesale banking and are continuing, to expand their
international activities. (Useful websites: www.bba.org.uk, www.bcsb.co.uk)
The Balance Sheet of any clearing bank reveals that the main sterling assets are
advances to the private sector, other banks, the public sector in the form of Treasury
Bills and government stock, local authorities and private households. Nowadays, the
main instruments of lending by retail banks are overdrafts, term loans and mortgages.
Wholesale banks
Wholesale banking (or merchant banking) developed out of the need to finance the
enormous growth in world trade in the 19th century. Accepting houses were formed
whose main business was to accept Bills of Exchange (promising to pay a sum of money
at some future date) from less well-known traders, and from discount houses which
provided cash by discounting such bills. Merchant banks nowadays concentrate on
dealing with institutional investors, large corporations and governments. They have
three major activities, frequently organised into separate divisions: corporate finance,
mergers and acquisitions, and fund management.
Merchant banks’ activities include giving financial advice to companies and arranging
finance through syndicated loans and new security issues. Merchant banks are also members of the Issuing Houses Association, an organisation responsible for the flotation of
shares on the Stock Exchange. This involves advising a company on the correct mix of
financial instruments to be issued and on drawing up a prospectus and underwriting
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28 Part I A framework for financial decisions
building societies
Financial institutions whose
main function is to accept
deposits from customers and
lend for house purchase
the issue. They also play a leading role in the development of new financial products, such
as swaps, options and other derivative products, that have become very widely traded
in recent years.
Another area of activity for wholesale banks is advising companies on corporate
mergers, acquisitions and restructuring. This involves both assisting in the negotiation of
a ‘friendly’ merger of two independent companies and also developing strategies for
‘unfriendly’ takeovers, or acting as an adviser for a company defending against an
unwanted bidder.
Finally, merchant banks fulfil a major role as managers of the investment portfolios of
some pension funds, insurance companies, investment and unit trusts, and various
charities. Whether in arranging finance, advising on takeover bids or managing the
funds of institutional investors, merchant banks exert considerable influence on both
corporate finance and the capital market.
The growth of overseas banking has been closely linked to the development of Eurocurrency markets and to the growth of multinational companies. Over 300 foreign
banks operate in London. A substantial amount of their business consists of providing
finance to branches or subsidiaries of foreign companies.
Building societies (www.buildingsociety.html, www.bsa.org.uk) are a form of savings
bank specialising in the provision of finance for house purchase in the private sector.
As a result of deregulation of the financial services industry, building societies now
offer an almost complete set of private banking services, and the distinction between
them and the traditional banks is increasingly blurred. Indeed, many societies have
given up their mutual status to become public limited companies, e.g. Northern Rock.
Self-assessment activity 2.1
What are financial intermediaries and what economic services do they perform?
(Answer in Appendix A at the back of the book)
■
Institutions engaged in contractual savings
Pension funds accumulate funds to meet the future pension liabilities of a particular
organisation to its employees. Funds are normally built up from contributions paid by
the employer and employees. They can be divided into self-administered schemes,
where the funds are invested directly in the financial markets; and insured schemes,
self-administered schemes
where the funds are invested by, and the risk is covered by, a life assurance company.
A pension fund that invests
client’s contributions directly
Pension schemes have enormous and rapidly growing funds available for investment
into the stock market and other in the securities markets. Pension funds enjoy major tax advantages. Subject to certain
investments
restrictions, individuals enjoy tax relief on their subscriptions to a fund. In turn, the
insured schemes
fund’s income and capital gains are tax-free. Together with insurance companies, penA pension fund that uses an
sion funds comprise the major purchasers of company securities.
insurance company to invest
contributions and to insure
Insurance companies’ activities (www.abi.org.uk) can be divided into long-term and
against actuarial risks (e.g.
general
insurance. Long-term insurance business consists mainly of life assurance and
members living longer than
pension provision. Policyholders pay premiums to the companies and are guaranteed
expected)
either a lump sum in the event of death, or a regular annual income for some defined
insurance companies
period. With a guaranteed premium inflow and predictable aggregate future payFinancial institutions that guarantee to protect clients against
ments, there is no great need for liquidity, so life assurance funds are able to invest
specified risks, including death,
heavily in long-term assets, such as ordinary shares.
and general risks in return for the
General insurance business (e.g. fire, accident, motor, marine and other insurance) conpayment of an annual premium
sists of contracts to cover losses within a specified period, normally 12 months. As liquidity is important here, a greater proportion of funds is invested in short-term assets,
although a considerable proportion of such funds is invested in securities and property.
pension funds
Financial institutions that manage the pension schemes of large
firms and other organisations
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Chapter 2 The financial environment
portfolios
Combinations of securities of
various kinds invested in a
diversified fund
■
29
The investment strategy of both pension fund managers and insurance companies
tends to be long-term. They invest in portfolios of company shares and government
stocks, direct loans and mortgages.
Other investment funds: unit and investment trusts
As we shall see in Section 2.4, private investors, independently managing their own
investment portfolios, are a dying breed. Increasingly, they are being replaced by financial institutions that manage widely diversified portfolios of securities, such as unit trusts
and investment trusts (www.investmentfunds.org.uk). These pool the funds of large numbers of investors, enabling them to achieve a degree of diversification not otherwise
attainable owing to the prohibitive transactions costs and time required for active portfolio management. However, there are important differences between these institutions.
Investment trusts
Investment trusts are limited companies, whose shares are usually quoted on the Stock
Exchange, and set up specifically to invest in securities. The company’s share price
depends on the value of the securities held in the trust, but also on supply and demand.
As a result, these shares often sell at values different from their net asset values, usually
at a discount.
They are traditionally ‘closed-ended’ in the sense that the company’s articles restrict
the number of shares, and hence the amount of share capital, that can be issued.
However, several open-ended investment trust companies (OEICS) have now been
launched. To realise their holdings, shareholders can sell their shares on the stock market.
Unit trusts
Unit trusts are investment syndicates, established by trust deed and regulated by trust
law. Investors’ funds are pooled into a portfolio of investments, each investor being
allocated tranches or ‘units’ according to the amount of the funds they subscribe. They
are mainly operated by banks and insurance companies, which appoint managers
whose conduct is supervised by a set of trustees.
Unit prices are fixed by the managers, but reflect the value of the underlying securities. Prices reflect the costs of buying and selling, via an initial charge. Managers also
apply annual charges, usually about 1 per cent of the value of the fund. Unit-holders
can realise their holdings only by selling units back to the trust managers.
They are ‘open-ended’ in the sense that the size of the fund is not restricted and the
managers can advertise for funds.
Disintermediation and securitisation
disintermediation
Business-to-business lending
that eliminates the banking
intermediary
securitisation
The capitalisation of a future
steam of income into a single
capital value that is sold on the
capital market for immediate
cash
While financial intermediaries play a vital role in the financial markets, disintermediation is an important new development. This is the process whereby companies borrow
and lend funds directly between themselves without recourse to banks and other institutions. Allied to this is the process of securitisation, the development of new financial
instruments to meet ever-changing corporate needs (i.e. financial engineering). Some
assets generate predictable cash returns and offer security. Debt can be issued to the market on the basis of the returns and suitable security. Securitisation usually also involves
a credit rating agency assessing the issue and giving it a credit rating. Securitisation can
also be used to create value through ‘unbundling’ traditional financial processes. For
example, a conventional loan has many elements, such as loan origination, credit status
evaluation, financing and collection of interest and principal. Rather than arranging the
whole process through a single intermediary, such as a bank, the process can be ‘unbundled’ and handled by separate institutions, which may lower the cost of the loan.
Securitisation and disintermediation have permitted larger companies to create
alternative, more flexible forms of finance. This, in turn, has forced banks to become
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30 Part I A framework for financial decisions
more competitive in the services offered to larger companies. Recent more exotic forms
of securitisation include pubs, gate receipts from a football club, future income from a
pop star’s recordings, and even the football World Cup competitions for 2002 and 2006.
Securitising the Beatles
Chrysalis, the media group, has completed a complex cross-border securitisation deal to unlock
£60 million over 15 years against the future value of its music publishing catalogue which
includes artists ranging from Blondie, the Beatles, Jethro Tull to David Gray and Moloko.
Music publishing is a separate business from recorded music, comprising the rights to the
written composition of a song, performance rights such as radio airplay, a share of CD sales
and synchronisation rights from use in advertisements or films. Chrysalis’s revenues from its
catalogue were £8 million in 2000.
The Chrysalis securitisation deal took 18 months to structure because of the complexity in
bringing together publishing rights in the UK, US, Germany, Sweden and Holland under their
different tax regimes.
Chrysalis follows in the footsteps of the singer-songwriter, David Bowie, who recently raised
$55 million via a bond issue against his share of the publishing rights to his compositions.
Source: Based on Financial Times, 2 March 2001.
2.4
THE LONDON STOCK EXCHANGE (LSE)
The capital market is the market where long-term securities are issued and traded. The
London Stock Exchange is the principal trading market for long-dated securities in the
UK (www.londonstockexchange.com).
A stock exchange has two principal economic functions: to enable companies to
raise new capital (the primary market), and to facilitate the trading of existing shares (the
secondary market) through the negotiation of a price at which title to ownership of a
company is transferred between investors. Secondary trading dwarfs the issue of new
ordinary shares. In 2004, secondary turnover in UK companies was £2,316 billion by
value, involving 2.15 million ‘bargains’ (deals). By contrast, new money raised by UK
firms in the same year was only £16 billion.
■
A brief history of the London Stock Exchange
The world’s first joint-stock company – the Muscovy Company – was founded in
London in 1553. With the growth in such companies, there arose the need for shareholders to be able to sell their holdings, leading to a growth in brokers acting as intermediaries for investors. In 1760, after being ejected from the Royal Exchange for
rowdiness, a group of 150 brokers formed a club at Jonathan’s Coffee House to buy and
sell shares. By 1773, the club was renamed the Stock Exchange.
The Exchange developed rapidly, playing a major role in financing UK companies
during the Industrial Revolution. New technology began to have an impact in 1872,
when the Exchange Telegraph tickertape service was introduced.
For over a century, the Exchange continued to expand and become more efficient,
but fundamental changes did not occur until 27 October 1986 – ‘Big Bang’ – the most
important of which were:
1 All firms became brokers/dealers able to operate in a dual capacity – either buying securities from, or selling them to, clients without the need to deal through a
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Chapter 2 The financial environment
31
third party. Firms could also register as market makers committed to making firm
bid (buying) and offer (selling) prices at all times.
2 Ownership of member firms by an outside corporation was permitted, enabling
member firms to build a large capital base to compete with competition from
overseas.
3 Minimum scales of commission were abolished to improve competitiveness.
4 Trading moved from being conducted face-to-face on a single market floor to being
performed via computer and telephone from separate dealing rooms. Computerbased systems were introduced to display share price information, such as SEAQ
(Stock Exchange Automated Quotations).
The Alternative Investment Market (AIM) was introduced in 1995, to provide a market that is accessible to both investors and companies from a wide range of backgrounds,
including start-ups and established firms. In 2004, AIM celebrated its 1,000th listing. By
the end of that year, 1,020 UK and international companies were listed on AIM with total
capitalisation of £31.75 billion. The total value of secondary deals on AIM in 2004 was
£18.2 billion, while AIM firms raised £4.6 billion in new issues.
In 1997, the settlement service for exchanging shares and associated payment
moved to the CREST electronic settlement system. In the same year, the Stock
Exchange Electronic Trading Service (SETS) was launched to bring greater speed and
efficiency to the market. Today, the London Stock Exchange is viewed as one of the
leading and most competitive places to do business in the world, second only to New
York in total market value terms.
The LSE has two tiers. The bigger market is the Main List, providing a quotation for
2,753 companies (as at August 2004). To obtain a full listing, companies have to satisfy rigorous criteria laid down in the Stock Exchange’s ‘Listing Rules’ (or ‘Yellow
Book’). These relate to size of issued capital, financial record, trading history and
acceptability of board members. These details are set out in a document called the
company’s ‘listing particulars’.
The second tier is the Alternative Investment Market (AIM). It attempts to minimise the cost of entry and membership by keeping the rules and application process
as simple as possible. A nominated adviser firm (typically a stock broker or bank)
both introduces the new company to the market and acts as a mentor, ensuring that
it complies with market rules. Although the majority of companies are capitalised at
between £2 million and £20 million, it also includes start-up operations at one end
and companies capitalised at over £200 million at the other. However, the requirement to observe existing obligations in relation to publication of price-sensitive
information and annual and interim accounts remains. The AIM is unlikely to
appeal to private investors unless they are prepared to invest in relatively high-risk
businesses.
While the vast majority of share trading takes place through the Stock Exchange, it
is not the only trading arena. For some years, there has been a small, but active OverThe-Counter (OTC) Market, where organisations trade their shares, usually on a
‘matched bargain’ basis, via an intermediary.
Self-assessment activity 2.2
What type of company would be most likely to trade on:
(a) the Main Securities Market?
(b) the Alternative Investment Market?
(c) The Over-The-Counter Market?
(Answer in Appendix A at the back of the book)
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Regulation of the market
Investor confidence in the workings of the stock market is paramount if it is to operate
effectively. Even in deregulated markets, there is still a requirement to provide strong
safeguards against unfair or incompetent trading and to ensure that the market operates as intended. The mechanism for regulating the whole UK financial system was
established by the Financial Services Act 1986 (FSA86), which provided a structure
based on ‘self-regulation within a statutory framework’.
In 1997, statutory powers were vested in a supervisory body, the Financial Services
Authority (FSA), responsible to the Treasury. Its objectives are to sustain confidence in
the UK’s financial services industry and monitor, detect and prevent financial crime
(www.fsa.gov.uk). This involves the regulation of the financial markets, investment
managers and investment advisors.
The FSA also takes on additional responsibilities for monitoring the Bank of England
and money markets, building societies and the insurance market. The hope is that, by
having a single regulator covering all financial markets, there will be greater efficiency,
lower costs, clearer accountability and a single point of service for customer enquiries
and complaints.
In an attempt to enhance London’s reputation for clean and fair markets, the FSA
has introduced new powers, effective from 2000, to deal with insider dealing and
attempts to distort prices. It is a criminal offence to undertake ‘investment business’
without due authorisation. A Recognised Investment Exchange (RIE), of which the
London Stock Exchange is one, may also receive authorisation. Recognition exempts
an exchange (but not its members) from needing authorisation for any activity constituting investment business.
The Stock Exchange discharges its responsibilities by:
■
■
■
■
■
vetting new applicants for membership
monitoring members’ compliance with its rules
providing services to aid trading and settlement of members’ business
supervising settlement activity and management of settlement risk
investigating suspected abuse of its markets.
Market abuse includes three strands:
(a) Market distortion – acting in such a manner as to force up a company’s share price.
(b) Misuse of information – e.g. buying or selling shares on the basis of privileged
information.
(c) Creating false information – e.g. putting false information on to a website.
FSA86 also gave the Exchange responsibility for regulating both the admission of
companies to the Official List and their ongoing compliance with the listing requirements. Companies violating the Exchange’s rules of conduct can have their listings
removed.
Other bodies also keep a watchful eye on the workings of capital markets. These
include the Bank of England (www.bankofengland.co.uk), the Competition Commission
(CC), the Panel on Takeovers and Mergers, the Office of Fair Trading, the press and
various government departments.
Self-assessment activity 2.3
To what extent does an effective primary capital market depend on a healthy secondary
market?
(Answer in Appendix A at the back of the book)
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33
Share ownership in the UK
Back in 1963, over half (54 per cent) of all UK equities were held by private individuals. This proportion had dropped to 14.9 per cent by the end of 2003 (www.statistics.
gov.uk). Today, share ownership is dominated by financial institutions (the pension
funds, insurance groups and investment and unit trusts). Together, including both UK
and foreign institutions, they own around 80 per cent of the value of UK traded companies. These impersonal bodies, acting for millions of pensioners and employees, policyholders and small investors, have vast power to influence the market and the
companies they invest in. Institutional investors employ a variety of investment strategies, from passive index-tracking funds, which seek to reflect movements in the stock
market, to actively managed funds.
Institutional investors have important responsibilities, and this can create a dilemma: on the one hand, they are expected to speak out against corporate management
policies and decisions that are deemed unacceptable environmentally, ethically or
economically. But public opposition to the management could well adversely affect
share price. Institutions therefore have a conflict between their responsibilities as
major shareholders and their investment role as managers seeking to outperform the
markets.
A further indication of changing patterns of share ownership is the proportion of
the adult population that holds shares. Successive governments have promoted a
‘share-owning democracy’, particularly through privatisation programmes. However,
individuals tend to hold small, undiversified portfolios – over half of private investors
hold just one security – which exposes them to a greater degree of risk than from
investing in a diversified investment portfolio.
■
Towards a European stock market
The European Union is meant to be about removing barriers and providing easier
access to capital markets. Until recently, this was still a pipe dream, with some 30 stock
exchanges within the EU, most of which had different regulations. With the introduction of a single currency, there will undoubtedly be strong pressure towards a single
capital market. But does this mean a single European stock exchange, with one set of
rules for share listing and trading?
Euronext was formed in 2000 as a result of the merger of the Amsterdam, Brussels and
Paris stock exchanges. As the first pan-European stock exchange, it has already undertaken further mergers with other smaller exchanges in Europe (e.g. LIFFE, Lisbon),
which is exerting more pressure on the London and Frankfurt exchanges. These two
exchanges attempted, but failed, to merge in 2000. The New York Stock Exchange is easily the largest in terms of market value, while Nasdaq, the US exchange for young
growth companies, has the most companies listed.
However, the London market lists the greatest number of foreign companies. At
year-end 2004, there were some 450 foreign firms listed on the main market, the majority from the USA, Western Europe and the Commonwealth countries, but including
representation from Russia, Hungary and China.
The box below gives the examples of Inion, a Finnish Company, maker of biodegradable plates for mending broken bones. Inion announced plans to list in London in 2004,
Its market value at floatation was £72 million.
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34 Part I A framework for financial decisions
Inion plans £30m public offering
Inion, a Finnish medical devices company,
is planning to raise £30m in an initial public offering on the London Stock Exchange.
The indicative price range for the flotation has been set at between 113p and
136p a share, giving a market capitalisation of between £80m and £90m.
The company, which makes biodegradable polymer implants, was set up in 1999
by senior researchers from Bionics, a
Nasdaq-listed Finnish implants company.
Auvo Kaikkonen, chief executive, said
listing alongside other medical technology
companies in London would ensure better
2.5
FT
liquidity than floating on the Helsinki Stock
Exchange, which is dominated by Nokia.
‘We wanted a market where there was an
experienced analyst and investor community,’ he said.
Inion’s products include biodegradable
screws, plates and meshes to stabilise broken and damaged bones while they heal.
Inion incurred a pre-tax loss of approximately ;3m (£2.1m) on revenues of ;2.4m
in the first half of 2004. Mr Kaikkonen
said it would break even when revenues
reached ;20m.
Source: Financial Times, 10 November 2004.
ARE FINANCIAL MARKETS EFFICIENT?
allocative efficiency
The most efficient way that a
society can allocate its overall
stock of resources
operating/technical
efficiency
The most cost-effective way of
producing an item, or organising a process
social efficiency
The extent to which a socioeconomic system accords with
prevailing social and ethical
standards
pricing/information
efficiency
The extent to which available
information is impounded into
the current set of share prices
fair game
A competitive process in which
all participants have equal
access to information and
therefore similar chances of
success
arbitrage
The process whereby astute
entrepreneurs identify and
exploit opportunities to make
profits by trading on differentials in price of the same item
as between two locations or
markets
If financial managers are to achieve corporate goals, they require well-developed financial markets where transfers of wealth from savers to borrowers are efficient in both
pricing and operational cost.
Efficiency can mean many things. The economist talks about allocative efficiency –
the extent to which resources are allocated to the most productive uses, thus satisfying
society’s needs to the maximum. The engineer talks about operating or technical efficiency – the extent to which a mechanism performs to maximum capability. The sociologist and the political scientist talk about social efficiency – the extent to which a
mechanism conforms to accepted social and political values. The most important concept of efficiency for our purposes is pricing or information efficiency. This refers to the
extent to which available information is built into the structure of share prices. If information relevant for assessing a company’s future earnings prospects (including both
past information and relevant information relating to future expected events) is widely and cheaply available, then this will be impounded into share prices by an efficient
market. As a result, the market should allow all participants to compete on an equal
basis in a so-called fair game.
We often hear of the shares of a particular company being ‘under-valued’ or ‘over-valued’, the implication being that the stock market pricing mechanism has got it wrong and
that analysts know better. In an efficient stock market, current market prices fully reflect available information and it is impossible to outperform the market consistently, except by luck.
Consider any major European stock market. On any given trading day, there are
hundreds of analysts – representing the powerful financial institutions which dominate the market – closely tracking the daily performance of the share price of, say,
Wimpey, the construction company. They each receive at the same time new information from the company – a major order, a labour dispute or a revised profits forecast.
This information is rapidly evaluated and reflected in the share price by their decisions
to buy or sell Wimpey shares. The measure of efficiency is seen in the extent and speed with
which the market reflects new information in the share price.
The Law of One Price suggests that equivalent securities must be traded at the
same price (excluding differences in transaction costs). If this is not the case, arbitrage opportunities arise whereby a trader can buy a security at a lower price and
simultaneously sell it at a higher price, thereby making a profit without incurring
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Chapter 2 The financial environment
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any risk. In an efficient market, arbitrage activity will continue until the price differential is eliminated.
■
The Efficient Market Hypothesis (EMH)
Information can be classified as historical, current or forecast. Only current or historical information is certain in its effect on price. The more information that is available
the better the situation. Informed decisions are more likely to be correct, although the
use of inside information to benefit from investment decisions (insider dealing) is illegal in the UK.
Company information is available both within and without the organisation.
Those within the organisation will obviously be better informed about the state of the
business. They have access to sensitive information about future investment projects,
contracts under negotiation, forthcoming managerial changes, etc. The additional
knowledge will vary according to a person’s level of responsibility and place in the
organisational hierarchy.
Outsider investors fall into two categories: individual investors and the institutions.
Of these two groups, the institutions are the better informed, as they have greater
access to senior management, and may be represented on the board of directors.
Different amounts of financial information are available to different groups of people. There is unequal access to the information, called ‘information asymmetry’, which
may affect a company’s share price. If you are one of the well-informed, this gives you
the opportunity to keep one step ahead of the market. Otherwise, you may lose out.
The share price reflects who knows what about the company. You should note, however, that in the UK, share dealings by company directors are tightly circumscribed; for
example, they can only buy and sell at specific times, and details of all such trades
must be publicly disclosed.
Market efficiency evolved from the notion of perfect competition, which assumes
free and instantly available information, rational investors and no taxes or transaction
costs. Of course, such conditions do not exist in capital markets, so just how do we
assess their level of efficiency? Market efficiency, as reflected by the Efficient Markets
Hypothesis (EMH), may exist at three levels:
weak form
A weak-form efficient share
market does not allow investors
to look back at past share price
movements and identify clear,
repetitive patterns
semi-strong form
A semi-strong efficient share
market incorporates newly
released information accurately
and quickly into the structure
of share prices
strong form
In a strong-form efficient share
market, all information including inside information is built
into share prices
1 The weak form of the EMH states that current share prices fully reflect all information contained in past price movements. If this level of efficiency holds, there is no value
in trying to predict future price movements by analysing trends in past price movements. Efficient stock market prices will fluctuate more or less randomly, any
departure from randomness being too expensive to determine. Share prices are said
to follow a random walk.
2 The semi-strong form of the EMH states that current market prices reflect not only
all past price movements, but all publicly available information. In other words, there
is no benefit in analysing existing information, such as that given in published
accounts, dividend and profits announcements, appointment of a new chief executive or product breakthroughs, after the information has been released. The stock
market has already captured this information in the current share price.
3 The strong form of the EMH states that current market prices reflect all relevant
information – even if privately held. The market price reflects the ‘true’ or intrinsic
value of the share based on the underlying future cash flows. The implications of
such a level of market efficiency are clear: no one can consistently beat the market
and earn abnormal returns. Few would go so far as to argue that stock markets are
efficient at this level.
You will have noticed that as the EMH strengthens, the opportunities for profitable
speculation reduce. Competition between well-informed investors drives share prices
to reflect their intrinsic values.
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36 Part I A framework for financial decisions
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The EMH and fundamental and technical analysis
intrinsic worth
The inherent or fundamental
value of a company and its
shares
fundamental analysis
Analysis of the fundamental
determinants of company
financial health and future performance prospects, such as
endowment of resources, quality of management, product
innovation record, etc.
technical analysis
The detailed scrutiny of past
time series of share price movements attempting to identify
repetitive patterns
chartists
Analysts who use technical
analysis
Investment analysts who seek to determine the intrinsic worth of a share based on
underlying information undertake fundamental analysis. The EMH implies that fundamental analysis will not identify under-priced shares unless the analyst can respond
more quickly to new information than other investors, or has inside information.
Chapter 4 adopts a fundamental analysis approach in its examination of share valuation.
Another approach is technical analysis, its advocates being labelled chartists
because of their reliance upon graphs and charts of price movements. Chartists are not
interested in estimating the intrinsic value of shares, preferring to develop trading
rules based on patterns in share price movement over time, or ‘breakout’ points of
change. Charts are used to predict ‘floors’ and ‘ceilings’, marking the end of a share
price trend. Figure 2.2 shows how charts are used to detect patterns of ‘resistance’ (for
shares on the way up) and ‘support’ (for shares on the way down). This approach can
often prove to be a ‘self-fulfilling prophecy’. In the short term, if analysts predict that
share prices will rise, investors will start to buy, thus creating a bull market and resulting in upward pressure on prices.
Even in its weak form, the EMH questions the value of technical analysis; future price
changes cannot be predicted from past price changes. However, the fact that many analysts, using fundamental or technical analysis, make a comfortable living from their
investment advice, suggests that many investors find comfort in the advice given.
Considerable empirical tests on market efficiency have been conducted over
many years. In the USA and the UK, until the 1987 stock market crash, the evidence
broadly supported the semi-strong form of efficiency. More specifically, it suggests
the following:
1 There is little benefit in attempting to forecast future share price movements by analysing
past price movements. As the EMH seems to hold in its weak form, the value of charts
must be questioned.
2 For quoted companies that are regularly traded on the stock market, analysts are
unlikely to find significantly over- or under-valued shares through studying publicly held
information. Studies indicate (e.g. Ball and Brown 1968) that most of the information
content contained in annual reports and profit announcements is reflected in share
prices anything up to a year before release of the information, as investors make
judgements based on press releases and other information during the year. However,
analysts with specialist knowledge, paying careful attention to smaller, less welltraded shares, may be more successful. Equally, analysts able to respond to new
information slightly ahead of the market may make further gains. The semi-strong
form of the EMH seems to hold fairly well for most quoted shares.
Breakout
Resistance line
Share
price
Support line
Figure 2.2
Chart showing breakout beyond resistance
line
time
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Chapter 2 The financial environment
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3 The strong form of the EMH does not hold, so superior returns can be achieved by
those with ‘inside knowledge’. However, it is the duty of directors to act in the shareholders’ best interests, and it is a criminal offence to engage in insider trading for
personal gain. The fact that cases of insider trading have led to the conviction of senior executives shows that market prices do not fully reflect unpublished information.
Recent governments have encouraged greater market efficiency in several ways:
■
■
■
Stock market deregulation and computerised dealing have enabled speedier adjustment of share prices in response to global information.
Mergers and takeovers have been encouraged as ways of improving managerial
efficiency. Poorly performing companies experience depressed share prices and
become candidates for acquisition.
Governments have seen privatisation of public utilities as a means of subjecting
previously publicly-owned organisations to market pressures.
How people trade in London
The Big Bang in 1986 gave the London Stock Exchange a huge advantage over most of
its competitors. The result was strong growth in trading activity and international participation. But Big Bang was only a partial revolution – automating the distribution of
price information, but stopping short of automating the trading function itself.
Since 1986, global equity markets have become increasingly complex, with investors
constantly looking for greater choice and lower costs. The London Stock Exchange
made various attempts to retain its reputation as one of the most efficient stock markets. In 1997, it took a major step by moving from a quote-based trading system, under
which share dealing is conducted by telephone, to order-driven trading, termed SETS –
the Stock Exchange Electronic Trading Service. The aim was to improve efficiency and
reduce costs by automating trading and narrowing the spread between buying and selling prices. This it achieves by the automatic matching of orders placed electronically by
prospective buyers and sellers.
The system, which initially only applies to heavily traded shares, works as follows.
Instead of agreeing to trade at a price set by a market maker, prospective buyers and
sellers can:
(a) advertise through their broker the price at which they would like to deal, and wait
for the market to move, or
(b) execute immediately at the best price available.
An investor wishing to buy or sell will contact his or her broker and agree a price
at which the investor is willing to trade. The broker enters the order in the order book,
which is then displayed to the entire market along with other orders. Once the order
is executed, the trade is automatically reported to the Exchange. Time will tell whether
it does lead to greater efficiency, but it is hoped that it will offer users more attractive,
transparent and flexible trading opportunities.
Heads, shoulders and broadening bottoms
The popularity of business television channels such as CNBC has done wonders for the careers
of Wall Street’s technical analysts, who claim to be able to predict future share prices by spotting trends in past prices. Their market charts, showing descriptively named patterns such as
‘head and shoulders’ – a big peak surrounded by two smaller peaks – or ‘broadening bottoms’ –
a series of troughs, each lower than the preceding one – make ideal graphics for television
Continued
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38 Part I A framework for financial decisions
producers in need of something pretty for viewers to watch while the glamorous reporters are
busy off-camera, catching up on the latest market gossip. The simple trading advice conveyed
by charts is, for CNBC’s stock-tip-hungry viewers, manna from heaven.
But technical analysis is not merely for gullible CNBC-watchers. It has been around a long
time, dating back a century to Charles Dow, the founder of Dow Jones, who invented the ‘Dow
theory’ for identifying trends in share prices. Charts are used by some of the world’s most successful investors.
Nevertheless, economists who study financial markets have long regarded technical analysis
as mumbo jumbo, bearing much the same relationship to rigorous economic ‘fundamental
analysis’ that astrology does to astronomy. Since the 1960s, economists have believed, more
or less, in ‘efficient-market theory’. In an efficient market, prices reflect all available information, and so scouring past prices for patterns can tell you nothing useful about whether in
future prices will go up or down. Instead, prices will move unpredictably, in a ‘random walk’.
In the past decade some economists have challenged efficient-market theory, by finding
numerous examples of apparently predictable movements in share prices. But there is still a
fierce debate about whether these movements are predictable enough for investors to make
money trading on the basis of expected price changes. The evidence was described at length in
A Non-Random Walk Down Wall Street (Princeton University Press, 1999), a book by Craig
MacKinlay, of the Wharton School, and Andrew Lo, of the Massachusetts Institute of
Technology.
Mr Lo and two new co-authors have now come to the defence of technical analysis.* Using
American share prices during 1962–96, they investigated the predictive ability of five pairs of
widely-used technical patterns. The results showed that the various technical patterns mostly
occurred far more frequently than they would have done if they were truly random events. The
most common patterns were double tops and bottoms – two peaks (or two troughs) at similar
prices to each other – followed by head and shoulders and inverted head and shoulders. In
general, the charts contained useful information about future share prices. The study does not
test whether this information was useful enough to allow investors to make sufficient profit
trading on it to justify the extra risk.
Since investors have been using charts for 100 years or so and they still seem to work, the
patterns may be so deeply ingrained that their predictive powers will persist come what may.
*‘Foundations of technical analysis’ by Lo, Mamaysky and Wang, Journal of Finance, August 2000.
Source: Based on The Economist, 19 August 2000.
■
Implications of market efficiency for corporate managers
In quoted companies, managers and investors are directly linked through stock market prices, corporate actions being rapidly reflected in share prices. This indicates the
following:
1 Investors are not easily fooled by glossy financial reports or ‘creative accounting’
techniques, which boost corporate reported earnings but not underlying cash flows.
2 Corporate management should endeavour to make decisions that maximise shareholder wealth.
3 The timing of new issues of securities is not critical. Market prices are a ‘fair’ reflection of the information available and accurately reflect the degree of risk in shares.
4 Where corporate managers possess information not yet released to the market,
there is an opportunity for influencing prices. For example, a company may retain
information so that, in the event of an unwelcome takeover bid, it can offer positive
signals.
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Chapter 2 The financial environment
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Self-assessment activity 2.4
Consider why a dealing rule like ‘Always buy in early December’ should be doomed to failure. This rule is designed to exploit the so-called ‘end-of-year-effect’ claiming that share
prices ‘always’ rise at the end of the year.
(Answer in Appendix A at the back of the book)
■
Surfing towards greater stock market efficiency
One of the essential requirements of stock market efficiency is that all participants have
roughly equal access to price-sensitive information. In the past, the big players – with
online databases – were able to obtain information, and thereby enjoy a competitive
advantage, well before the small investors who may have had to rely on the daily newspaper to keep abreast of recent events and price movements.
The Internet offers enormous scope for narrowing the information gap between big
and small market participants. This arises in various ways.
1 Company information. Electronic reporting of company information will result in a
significant enfranchisement of shareholders and enable greater accountability and
corporate governance. The electronic information revolution should also give rise
to a movement away from conventional accounting-based information to more
user-friendly shareholder information which focuses on the key determinants of
value. For example, customer satisfaction and market penetration may be regular
information as part of a ‘balanced scorecard’ performance measurement system.
Videos of AGMs, analysts’ presentations and information on ethical/environmental investment will become standard, enabling all investors to be kept up-to-date on
corporate progress.
2 Market information. There are already thousands of Web pages devoted to investment and personal finance information, much of which was hitherto only available
to professional users. Although a charge is made for real-time information, those
with share prices on a 20-minute delay are often free.
The following websites may be of interest:
Yahoo! (finance.yahoo.co.uk) focuses on providing share information for London,
Frankfurt and Paris, with links to the US exchanges.
Moneyworld (www.moneyworld.co.uk) covers a much wider range of financial services as well as share prices.
The website of the Motley Fool (www.fool.co.uk) also ‘exists to educate, amuse and
enrich the individual investor’.
However much information efficiency may improve through surfing the Web’s
financial pages, remember that the market is renowned for its occasional catastrophic
share price waves, which few can predict and even fewer ride.
Self-assessment activity 2.5
Share prices of takeover targets invariably rise before the formal announcement of a
takeover bid. What does this suggest for the EMH?
(Answer in Appendix A at the back of the book)
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Criticisms of the EMH
overreaction hypothesis
The notion that although stock
markets are essentially efficient
in reacting to new information,
they initially over-react, perhaps
in anticipation of further
good/bad news
■
Michael Jensen, a leading financial economist, argued in 1978 that ‘the efficient markets
hypothesis is the best-established fact in all of social science’. Why then is the EMH
debate still hotly disputed? The main issue is whether investors react correctly to new
information or whether they make systematic errors by over- or under-reacting. The
overreaction hypothesis argues that share prices tend to overshoot the true value due
to excessive optimism or pessimism by investors in their initial reactions to new information. There is some evidence for this in UK financial markets (Dissanaike 1997).
Much criticism of the EMH is misplaced because it is based on a misconception
of what the hypothesis actually says. For example, it does not mean that financial
expertise is of no value in stock markets and that a share portfolio might as well be
selected by sticking a pin in the financial pages. This is clearly not the case. It does
suggest, however, that in an efficient market, after adjusting for portfolio risk, fund
managers will not, on average, achieve returns higher than that of a randomly
selected portfolio. Roll (see Ross et al. 1991, p. 324) makes the point that publiclyavailable information need not be reflected in share prices. Instead, the link
‘between unreflected information and prices is too subtle and tenuous to be easily
or costlessly detected’.
Market efficiency also suggests that share prices are ‘fair’ in the sense that they
reflect the value of that stock given the available information. So shareholders need not
be unduly concerned with whether they are paying too much for a particular share.
The fact that many investors have done very well through investing on the stock
market should not surprise us. For much of the last century, the market generated positive returns. Most investment advice, if followed over a long period of time, is likely
to have done well; the point is that, in efficient markets, investors cannot consistently
achieve above-average returns except by chance.
A few apparent anomalies in the EMH
There appear to be three main anomalies in the EMH; the effects of size and timing, and
the periodic emergence of ‘bubbles’.
Size effects
Market efficiency seems to be less in evidence among smaller firms. Shares of smaller
companies tend to yield higher average returns than those of larger companies of comparable risk. Dimson and Marsh (1986) found that in the UK, on average, smaller firms
outperformed larger firms by around 6 per cent per annum. Some of the difference can
be accounted for by the higher risk and trading costs involved in dealing with smaller
companies. Another explanation is institutional neglect. Financial institutions dominating the stock market often neglect small firms offering what appear to be high
returns because the maximum investment is relatively small (if they are not to exceed
their normal 5 per cent maximum stake). The costs of monitoring and trading may not
warrant the sums involved.
Timing effects
In the longer term, disparities in share returns seem to correct themselves. A share performing poorly in one year is likely to do well the following year. Seasonal effects have
also been observed. At the other extreme, it has been observed that share performance
is related to the day of the week or time of the day. Prices tend to rise during the last
fifteen minutes of the day’s trading, but the first hour of Monday trading is generally
characterised by heavy selling. Investors may evaluate their portfolios over the weekend and decide what to sell first thing on Monday, but are more cautious in their buying decisions, preferring to take their broker’s advice.
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Stock market surges and bubbles
An investor holding a wide portfolio of shares (e.g. the FTA All-Share Index) for, say, 25
years, would have been rewarded handsomely. But the capital growth was not a steady
monthly appreciation; the bulk of it came in just a fraction of the investment period
through stock market surges. In an efficient market, few – if any – are clever enough to
be able to predict short-term stock market surges.
The famous South Sea Bubble of 1722 was one of the early speculative stock market
‘bubbles’ where investors adopt the ‘herd’ instinct and drive up prices well above any
rational valuation based on economic fundamentals. The economist J.M. Keynes
described this in terms of a ‘beauty contest’ where investors are not following their
own judgments but trying to guess how other investors are going to behave. The
Internet Bubble of 1999 shows that speculative bubbles are still with us and the cost of
following the trend can be considerable.
Black Monday
In October 1987, on ‘Black Monday’, share prices fell by 30 per cent or more on most of the
world’s stock markets. Had this collapse been triggered by some cataclysmic event, shareholders’
reactions could be easily explained as the efficient market reacting to new information. However,
Black Monday was not a reaction to external events, but rather a recognition that the prolonged
bull market had ended and that the speculative share price bubble had burst. This brings into
question the validity of the simple EMH, which implies that share prices cannot rise to the artificially high levels observed prior to the 1987 crash. The newly-introduced computer trading methods, which automatically sell shares when they fall below a predetermined level, were unable to
cope with such an adverse situation. It is now generally accepted that the EMH failed to explain
why the Dow Jones Industrials index plummeted 23 per cent in just a few hours.
This enigma has led to a re-evaluation of the simple EMH and the assumption that there is a
single ‘true’ value for shares; there may be a very wide range of plausible values. The EMH, if it
operates at all, does so in the weakest of forms and is most efficient when conditions are stable.
Black Monday’s crash adds credence to the Speculative Bubble theory. Stock market behaviour is based on inflating and bursting speculative bubbles, rather than fundamental analysis
based on new information. Investors buy shares because they believe that others will pay yet
more for them later, thus creating a bull market. Eventually, the bubble bursts and the market
corrects itself or crashes, depending on the size of the bubble.
Self-assessment activity 2.6
If the stock market is efficient, can no one beat the market average return?
(Answer in Appendix A at the back of the book)
2.6
A MODERN PERSPECTIVE – CHAOS THEORY
The EMH is based on the assertion that rational investors rapidly absorb new information about a company’s prospects, which is then impounded into the share price. Any
other price variations are attributable to random ‘noise’. This implies that the market
has no memory – it simply reacts to the advent of each new information snippet, registers it accordingly and settles back into equilibrium; in other words, all price-sensitive
events occur randomly and independently of each other.
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42 Part I A framework for financial decisions
The crash of 1987, possibly attributed to the market’s realisation that shares were
over-valued and triggered by the collapse of a relatively minor management buy-out
deal, has provoked more detailed scrutiny of the pattern of past share prices. This
has uncovered evidence that share price movements do not always conform to a
‘random walk’. For example, significant downturns happen more frequently than
significant upturns.
A new branch of mathematics, chaos theory, has been harnessed to help explain
such features. Observations of natural systems such as weather patterns and river systems often give a chaotic appearance – they seem to lurch wildly from one extreme to
another. However, chaos theorists suggest that apparently random, unpredictable patterns are governed by sets of complex sub-systems that react interdependently. These
systems can be modelled, and their behaviour forecast, but predictions of the behaviour of chaotic systems are very sensitive to the precise conditions specified at the start
of the estimation period. An apparently small error in the specification of the model
can lead to major errors in the forecast.
Edgar Peters (1991) has suggested that stock markets are chaotic in this sense.
Markets have memories, are prone to major price swings and do not behave entirely
randomly. For example, in the UK, he found that today’s price movement is affected
by price changes that occurred several years previously. The most recent changes,
however, have the biggest impact. In addition, he found that price moves were persistent, i.e. if previous moves in price were upwards, the subsequent price move was
more likely to be up than down. Yet chaos theory also suggests that persistent
uptrends are also more likely ultimately to result in major reversals!
Peters’ work suggests that world stock markets exhibit patterns that are overlaid
with substantial random noise. The more noise, the less efficient the market. In this
respect, the US markets appear to be more efficient than those in the UK and Japan.
Other observers suggest that markets are essentially rational and efficient, but succumb to chaos on occasions, with bursts of chaotic frenzy being attributed to speculative activity. This suggests some scope for informed insiders to outperform the market
during such periods.
Which view is right? Are stock markets efficient, chaotic or somewhere in between?
Pending the results of further research, it seems that corporate financial managers cannot necessarily regard today’s market price as a fair assessment of company value, but
that the market may well correctly value a company over a period of years. Examination
of long-term trends gives more insight than consideration of short-term oscillations. For
example, if a company’s share price persistently underperforms the market, then perhaps its profitability really is low, or its management poor, or it has failed to release the
right amount of information.
To conclude, it seems that the Efficient Markets Hypothesis does not hold, except
perhaps in its very weakest form, in today’s capital markets. Evolving from both the
EMH and chaos theory is a promising successor termed the Coherent Market
Hypothesis (CMH) based on a combination of fundamental factors and market sentiment or technical factors (see Vaga 1991). The CMH argues that capital markets are, at
any point in time, in one of the following states, depending on a combination of economic fundamentals and ‘crowd behaviour’ in the market:
■
■
■
■
Random walks – market efficiency with neutral fundamentals
Unstable transition – market inefficiency with neutral fundamentals
Coherence – crowd behaviour with bullish fundamentals
Chaos – crowd behaviour with bearish fundamentals.
We will have to wait to see how well it helps explain stock market behaviour.
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Chapter 2 The financial environment
43
Self-assessment activity 2.7
List three important changes to the London Stock Exchange brought about by the ‘Big
Bang’ in 1986 and discuss their impact on market efficiency.
(Answer in Appendix A at the back of the book)
2.7
SHORT-TERMISM IN THE CITY
Pressure to perform well has not only led fund managers to increase their activity levels in managing funds, but may also have led to a more short-term perspective regarding capital investment. The argument is that fund managers focus on the short-term
performance of companies in arriving at a valuation of their worth, placing excessive
emphasis on current profit performance and dividend payments. Such apparent behaviour is said to have two consequences. First, management, in order to keep up the price
of its stock, will tend to focus on producing the short-term results that it thinks the market wants to see. This results in management failing to undertake important long-term
investment in resources and research and development. Second, the volatility of shortterm corporate results will be exaggerated in securities markets, producing undesirable
fluctuations in stock prices.
This chain of argument gained support from a survey carried out by the
Department of Trade and Industry’s Innovation Advisory Board (1990), which suggested the City placed too high a priority on short-term profits and dividends at the
expense of R&D and other innovative investment.
The argument was supported by a Confederation of British Industry (CBI) survey
of major companies in 1987, in which 35 per cent doubted that financial institutions
take a long-term and strategic evaluation of their companies. As a result, the CBI set
up a task force to investigate the whole issue. Its report concluded that many UK companies have given insufficient weight to long-term development, but that this does not
arise primarily from City pressure. It arises mainly from underlying economic and
political factors, including inadequate profitability (Ferguson 1989).
The problem of short-termism has also been addressed by US researchers (e.g. Graves
1988), who argue that the increasing shareholder power of institutional investors has
had a damaging effect on R&D expenditure among US firms.
The EMH argues that rational investors will approve of any long-term investments
that make sound economic sense. They will not sell the stock of a fundamentally
sound firm undertaking long-term investments that promise remarkably high future
cash flows just because that firm has reported one bad trading period. Such short-term
stock shuttling is viewed as irrational behaviour.
The City rejects most allegations of short-termism, arguing that much of the responsibility for the lack of long-term innovative investment is attributable to managers’
preference for growth by acquisition, their poor record of commercial development
and their reward systems based on short-term targets. This view is advocated by
Marsh (1990), who claims that:
There is no evidence that shares are priced in a way which emphasises their short- rather
than long-run prospects. Nor is there any evidence that the market penalises long-term
investments or expenditure on R&D by awarding the shares of the company in question
a lower rating – indeed, quite the contrary.
He identifies ‘managerial short-termism’ as a key force behind poor investment in
the UK. When it comes to making plans for the future, managers’ perceptions are
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44 Part I A framework for financial decisions
influenced by their organisational systems and contexts, including the way they are
remunerated and rewarded; their time-horizons within the jobs; the role played by the
internal performance measurement and management accounting systems; and the
internal capital budgeting and project appraisal systems.
There is broad consensus among all parties to the debate that action is required to
improve communication between the City and industry. Emerging very clearly from the
debate on short-termism is that UK companies need to improve the information they
provide to the capital markets on their R&D activity and other strategic investments if
they are to achieve a market rating appropriate to their future expected profitability.
2.8
READING THE FINANCIAL PAGES
Corporate finance is changing so quickly that it is essential for students of finance to
read the financial pages in newspapers on a regular basis. In this section, we explain the
main information contained in the Share Service pages of the Financial Times, and other
newspapers.
■
The FT-SE Index
Every day, shares move up or down with the release of information from within the
firm, such as a revised profits forecast, or from an external source, such as the latest
government statistics on inflation or unemployment. To indicate how the whole share
market has performed, a share index is used, the most common being the FT-SE 100 –
familiarly known as ‘Footsie’. This index is based on the share prices of the 100 most
valuable UK quoted companies, (sometimes termed ‘blue chips’) mostly those with
capitalisations above £3 billion, with each company weighted in proportion to its total
market value. All the world’s major stock markets have similar indices (for example,
the Nikkei index in Japan, the Dow Jones index in the USA and the CAC-40 in France).
Every share index is constructed on a base date and base value. The FT-SE 100 started with a base value of 1000 at the end of 1983. By January 2005, the index stood at
around 4,800. Despite the collapse in world markets in 2000, and the subsequent slow
recovery in confidence (punctuated by a fresh collapse at the time of the Iraq war), this
still represented an annual compound growth rate of about 8 per cent, well above both
the rate of inflation and the yield on low-risk investments over the same period.
Moreover, it includes only capital appreciation – inclusion of dividend income would
raise this percentage to about a 12 per cent return.
The FT-SE Actuaries Share Indices reveal share movements by sector. Their total
gives the All-Share Index, representing the more frequently traded quoted companies,
and between 98 and 99 per cent of market capitalisation.
Other FT indices
In recent years, the Stock Exchange has introduced several new indices.
■
■
■
FT-SE 250 covers medium-sized companies too small to enter the FT-SE 100, with
capitalisations in the range £350 million to £3 billion, and accounting for some 14
per cent of UK market capitalisation. It is calculated both including and excluding
investment trusts.
FT-SE Actuaries 350 provides the benchmark for investors who wish to focus on the
more actively traded large and medium-sized UK companies, and covers 95 per
cent of trading by value. It thus combines the FT-SE 100 and the FT-SE 250.
FT-SE Small Cap offers investors a daily measure of the performance of about 500
smaller companies, accounting for about 2 per cent of market capitalisation.
Whereas the previous indices are calculated continuously, this is computed only at
the close of trading.
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Chapter 2 The financial environment
■
■
45
FT-SE Fledgling covers some 700 smaller companies taken from the main listing
and the Alternative Investment Market (AIM).
The techMARK range. These indices reflect the performance of innovative technology stocks listed on the techMARK market in the following sectors: computer
hardware, semi-conductors, telecoms equipment, computer services, internet and
software. The indices are:
(i) FT-SE techMARK All Share.
(ii) FT-SE techMARK 100. This covers the top 100 firms from the first index.
(iii) FT-SE techMARK medi-science. This covers medical science firms from the following sectors: pharmaceuticals, bio-technology, medical equipment and suppliers (excluding firms in the main FT-SE 100 index).
Using the published information
Financial managers and investors need to study the performance of the shares of their
company, both against the appropriate sector as a whole and also against competitors
within that sector. Two performance statistics that are most commonly reported are the
dividend yield and price:earnings ratio.
Dividend yield
This is the gross, or pre-tax, dividends of companies and whole sectors in the last year
as a percentage of their market value. Generally, sectors with low dividend yields are
those with companies where the market expects high growth. Often we observe that the
dividend yield for leading shares, and also on the overall index, is well below the return
investors could currently earn on a safe investment in Treasury Bills. This is because
shareholders are looking to a capital gain on top of the dividend yield to recompense
them for the higher risks involved.
Price:earnings (P:E) ratio
The P:E ratio is a much-used performance indicator. It is the share price divided by the
most recently reported earnings, or profit, per share. So for the sector, it is the total market value of the companies represented divided by total sector earnings. The P:E ratio
is a measure of the market’s confidence in a particular company or industry. A high P:E
usually indicates that investors have confidence that profits will grow strongly in
future, perhaps after a short-term setback, although irregular events like a rumoured
takeover bid will raise the P:E ratio if they lead to a higher share price.
Let us now turn to the performance of individual companies. Table 2.1 is an extract
from the London Share Service pages in the Financial Times, giving the Food and Drug
Table 2.1
Share price information
for the food retail
sector
52 week
Big Food
CaffeNro
Dairy Fm
Greggs
Morrison
Sainsbry
Somerfld
Tesco
Thorntns
WhitrdCh
Price
Chng
94
127
14
13114
3750
21512
27014
15434
32014
15312
18912
.......
114
50
112
2
34
12
12
1
Source: Financial Times, 11 January 2005.
high
low
Yld
P/E
Vol
‘000s
182
80
48
3.1
–
2.2
2.3
1.5
5.0
1.4
2.2
4.4
1.8
11.7
28.3
26.6
14.5
32.3
–
26.4
19.4
22.8
17.9
13,104
5
5
32
19,842
9,912
1,236
14,082
82
22
13212
154
3750
256
3075
311 2
17214
32134
*
168
220
8812
1
17114
242
12512
237
135
161
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46 Part I A framework for financial decisions
price:earnings
The ratio of price per ordinary
share to earnings (i.e. profit
after tax) per share (EPS)
2.9
Retailing sector on 11 January 2005. Different information is provided on Mondays
than on other days of the week. We will focus on a major supermarket chain, Tesco
Group. Bold names indicate members of the FTSE 100 index.
Transactions and prices of stocks are published continuously through SEAQ (the
Stock Exchange Automatic Quotation). Quoted prices assume that shareholders buying a share are entitled to any forthcoming dividend (cum div) unless this is expressly precluded. The symbol ‘xd’ (ex div, i.e. excluding dividends) would mean that new
investors are too late to qualify for it. The share price will accordingly be lower to
reflect the forgone dividend.
Tesco’s closing share price of 320 14p is up 12p from the previous day’s trading
with over 14 million shares traded in the day. The current price is just below its highest over the past year. Every Monday, the Financial Times publishes the dividend
cover and market capitalisation value (i.e. number of issued shares times current
share price).
The Yield of 2.2 per cent is the dividend yield, i.e. the dividend expressed as a proportion of the current share price. The price:earnings (P:E) ratio of 19.4 suggests that it
would take over 20 years for investors to get their money back in profit terms. Why
should anyone be willing to wait that long? Remember that the calculation compares
the last reported earnings per share with the current share price. Investors expect the
payback period to be far quicker than 20 years because they anticipate strong earnings
growth for Tesco.
TAXATION AND FINANCIAL DECISIONS
Few financial decisions are immune from taxation considerations. Corporate and personal taxation affects both the cash flows received by companies and the dividend income received
by shareholders. Consequently, financial managers need to understand the tax consequences of investment and financing decisions. Taxation may be important in three key
areas of financial management:
1 Raising finance. There are clear tax benefits in raising finance by issuing debt rather
than capital. Interest on borrowings attracts tax relief, thereby reducing the company’s tax bill, while a dividend payment on equity capital does not attract tax relief.
The tax system is thereby biased in favour of debt finance.
2 Investment in fixed assets. Spending on certain types of fixed asset attracts a form of tax
relief termed capital allowances. This is intended to stimulate certain types of investment, such as in industrial plant and machinery. The taxation implications of an
investment decision can be very important. We discuss capital allowances and tax
implications for investment decisions in Chapter 6.
3 Paying dividends. Until 1973, in the UK, company profits were effectively taxed
twice – first on the profits achieved and then again on those profits paid to
shareholders in the form of dividends. Such a ‘classical’ tax system (which still
exists in certain countries) is clearly biased in favour of retaining profits rather
than paying out large dividends. The UK taxation system is more neutral, the
same tax bill being paid (for companies making profits) regardless of the dividend
policy.
Finally, the corporate financial manager should understand not only how taxation affects the company, but also how it affects the company’s shareholders (www.
inlandrevenue.gov.uk). For example, some financial institutions (e.g. pension funds)
pay no tax; some shareholders pay tax at 20 per cent, while others pay higher-rate
income tax at 40 per cent. Some may prefer capital gains to dividends.
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Chapter 2 The financial environment
47
Self-assessment activity 2.8
Explain why it is important to consider the tax implications of financial and investment
decisions.
(Answer in Appendix A at the back of the book)
SUMMARY
This chapter has introduced readers to the financial and tax environment within which
financial and investment decisions take place.
Key points
■
Financial markets consist of numerous specialist markets where financial transactions occur (e.g. the money market, capital market, foreign exchange market, derivatives markets).
■
Financial institutions (e.g. banks, building societies, pension funds) provide a vital
service by acting as financial intermediaries between savers and borrowers.
■
Securitisation and disintermediation have permitted larger companies to create
alternative, more flexible forms of finance.
■
The London Stock Exchange operates two tiers: the Main List for larger established
companies, and the Alternative Investment Market which mainly caters for very
young companies.
■
An efficient capital market is one where investors are rational and share prices
reflect all available information. The Efficient Markets Hypothesis has been examined in its various forms (weak, semi-strong and strong). In all but the strong form,
it seems to hold up reasonably well, but it is increasingly unable to explain ‘special’
circumstances.
■
The problem of ‘short-termism’ may stem more from managerial attitudes than
those of investors.
■
Taxation can play a key role in financial management, particularly in raising
finance, investing in fixed assets and paying dividends.
Further reading
Brett (2003) provides a clear explanation of how to read the financial pages in the press. Clear
and more extensive introductions to capital markets are found in Foley (1991), and Weston
Copeland (1992), O’Shea (1986) and Redhead (1990).
The Stock Exchange Fact Book is published annually by the Stock Exchange. Two classic review
articles on market efficiency were written by Fama (1970 and 1992), while Rappaport (1987)
examines the implications for managers. Tests of capital market efficiency are found in Copeland
and Weston (2004) and Keane (1983), while some exceptions to efficiency are found in the June
1977 special issue of Journal of Financial Economics. Peters (1991, 1993) applies Chaos Theory
to stock markets. Discussion on short-termism in the City is found in Marsh (1990) and Ball
(1991). Mastering Finance (1997) offers useful articles on securitisation, financial intermediaries,
the role of financial markets, market efficiency and short-termism.
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48 Part I A framework for financial decisions
Useful websites
www.moneyfactor.co.uk
www.moneysupermarket.com
www.moneyextra.com
www.find.co.uk
www.moneynet.co.uk
www.ftourmoney.co.uk
APPENDIX
FINANCIAL STATEMENT ANALYSIS
Balance Sheet/position
statement
A financial statement that lists
the assets held by a business at
a point in time and explains
how they have been financed
(i.e. by owners’ capital and by
third party liabilities)
Profit and Loss
Account/income statement
Most readers will previously have undertaken a module in accounting and be familiar
with financial statements. This appendix provides a summary of the key elements in
analysing financial statements and the main ratios involved in interpreting accounts.
Investors, whether shareholders or bank managers, ask three basic questions when
they examine the accounts of a business:
■
■
A financial statement that
details for a specific time period
■
the amount of revenue earned
by a firm, the costs it has
incurred, the resulting profit
and how it has been distributed
(‘appropriated’)
cash flow statement
A financial statement that
explains the reasons for cash
inflows and outflow of a business, and highlights the resulting
change in cash position
■
Position – what is the current financial position, or state of affairs, of the business?
This question is addressed by examining the Balance Sheet, sometimes referred to
as the position statement.
Performance – how well has the business performed over the period of time we are
interested in, for example, the past year? This question is addressed by looking at
the Profit and Loss Account, otherwise termed the income statement.
Prospects – what are the likely prospects of the business for which we are considering investment? A bank manager would probably request a cash flow forecast, showing the expected cash receipts and payments for the coming year. However, published
accounts are historical documents and the shareholder will have to settle for the cash
flow statement for the past year. Clues as to the expected future prospects may be
found in the Chairman’s Statement frequently published with the accounts.
We will examine the three financial statements, drawing on the abridged accounts
of a fictitious company called Foto-U, a business specialising in offering instant photographs through photo booths in public places throughout Europe.
The Balance Sheet
fixed assets
Assets that remain in the
Balance Sheet for more than
one accounting period (i.e. they
are fixed in the Balance Sheet)
current assets
Assets that will leave the
Balance Sheet in the next
accounting period
intangible
Intangible assets cannot be
seen or touched, e.g. the image
and good reputation of a firm
Imagine it is possible to take a financial snapshot of Foto-U on the 31 March 2006, the
end of its trading year. What we would see are the very things we find in the Balance
Sheet. Looking at Foto-U’s balance sheet in Table 2.2, we see three main categories –
assets, creditors (or liabilities) and capital and reserves. This statement demonstrates
the ‘accounting equation’: the money invested in the business by shareholders and
creditors is represented by the assets in which they have been invested.
Where the cash came from
1sources offunds2
Where the cash went
1uses of funds2
Shareholders' of funds £78 m Creditors £60 m Assets £138 m
The more permanent assets (typically those with a life beyond a year) are termed
fixed assets while the less permanent are termed current assets. For Foto-U, intangible
fixed assets refer to patents and goodwill, the latter arising from acquiring another
company and paying more for it than the Balance Sheet value of its underlying assets.
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Chapter 2 The financial environment
Table 2.2
Foto-U plc
49
Balance Sheet as at 31 March 2006
2006
£m
2005
£m
15
117
132
10
92
102
25
29
3
9
66
24
25
–
5
54
Creditors: amounts falling due within one year
(60)
(62)
Net current assets (liabilities)
Total assets less current liabilities
Creditors*: amounts falling due after more than one year
Net assets
Capital and reserves
Called-up share capital
Reserves
Shareholders’ funds
6
138
(60)
78
(8)
94
(23)
71
2
76
78
2
69
71
40
42
Fixed assets
Intangible assets
Tangible assets
Current assets
Stocks
Debtors
Investments and short-term deposits
Cash at bank and in hand
*The creditors figures includes trade creditors
Profit and Loss Account for the year ended 31 March 2006
Turnover – continuing operations
Cost of sales (including depreciation of £27 m)
Gross profit
Administration expenses
Operating profit (Earnings before interest and taxes)
Interest payable
Profit before taxation
Tax on profit
Profit after tax attributable to shareholders
Dividends
Retained profit for year
200
(157)
43
(21)
22
(2)
20
(6)
14
(7)
7
190
(160)
30
(20)
10
(2)
8
(4)
4
(3)
1
36
(2)
(6)
(57)
(7)
37
13
43
(2)
(4)
(33)
(3)
2
6
Cash Flow Statement for the year ended 31 March 2006
Net cash inflow from operations
Servicing of finance
Taxation
Capital expenditure
Dividends paid
Financing
Increase in cash in the year
Other data: Foto-U has 200 million shares in issue.
Share price at 31 March 2006 is 120p (50p for 2005).
tangible
Tangible assets can quite literally be seen and touched, e.g.
machinery and buildings
net book value
The original cost of buying an
asset less accumulated depreciation charges to date
Tangible fixed assets include land and buildings, photo booths, plant and machinery,
vehicles and fixtures and fittings. Their values are not stated at what they could be
sold for, but at their net book value – what they originally cost less an estimate of the
extent to which they have depreciated in value with use or age.
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50 Part I A framework for financial decisions
net current assets
Current assets less current
liabilities
shareholders’ funds
The value of the owners’ stake
in the business–identically
equal to net assets, or equity
Current assets represent the less permanent items (typically less than a year) the
business owns at the balance sheet date. Our financial snapshot for Foto-U captures four
items – stocks, debtors, investments and cash. Unlike fixed assets, these items are continuously changing (or ‘turning over’) as trading takes place. Trade creditors and bank
overdraft, where the amount has to be settled within one year, are deducted from the
current assets to give the net current assets figure, commonly termed working capital.
This is the amount of money likely to be turned into cash over the coming weeks.
Creditors to be paid after more than a year are typically in the form of medium/
long-term loans. Finally, shareholders’ funds represent the capital originally paid in by
shareholders plus any reserves created since then. The most common reserve will be
the profit retained in the business rather than paid to the shareholders as dividends.
Does the balance sheet show the worth of the business?
Although the shareholders’ funds for Foto-U of £78 million is the difference between
what it owns, in the form of various assets, and what it owes to third parties, it would
not be correct to say that this is what their investment is worth. The market value for
the company is based on what investors are willing to pay for it. But the assets and liabilities are valued according to Generally Accepted Accounting Principles (GAAP).
We cannot explore them all here, but one principle is that assets are usually valued at
their historical cost less a provision for such things as depreciation, in the case of fixed
assets, and bad or doubtful debts, in the case of debtors. The key difference is that
book values, based on GAAP, are backward-looking, while market values are forwardlooking, based on expected future profits and cash flows.
To get some idea of the difference between the market and book values of the shareholders’ funds we can look at the share price listed on the Stock Exchange on the balance sheet date. For Foto-U the share price at the balance sheet date was 120p. There
are 200 million issued shares so the market capitalisation is:
1200 million shares 120p a share2 £240 million
Comparing the market value with the book value for shareholders’ equity, we find
a ratio of approximately 3:1 (£240 m/£78 m). We should not be surprised to find that the
market value is so much higher. Successful businesses are much more than a collection
of assets less liabilities. They include creative people, successful trading strategies,
profitable brands and much more. Generally, we can say that the greater the marketto-book value ratio, the more successful the business.
■
The profit and loss account
profit after tax (PAT)
Profit available to pay dividends
to shareholders after tax has
been paid
dividend
A periodic payment to a firm’s
owners–usually once or twice a
year–made out of profits after
tax
retained profit
Profit that remains for reinvestment in the business after
a dividend is paid out
operating profit
Revenues less total operating
costs, both variable and
fixed–as distinct from financial
costs such as interest payments.
To gain an impression of how well Foto-U has performed over the past year we need
to turn to the Profit and Loss Account or income statement. This shows the sales
income less the costs of trading. Shareholders are primarily interested in the profit
after tax (PAT) available for distribution to them in the form of dividends. Foto-U has
made a PAT of £14 million of which half has or will be paid to shareholders in the form
of dividend, the remainder being retained profit, reinvested in the business, hopefully
to earn a higher profit next year.
Investors also want to know how much profit (or earnings) has been made from its
trading, before the cost of financing is deducted. Earnings before interest and taxes
(EBIT) for Foto-U is:
EBIT total revenues operating costs 1including depreciation2
£200 m £178 m
£22 m
This is also termed operating profit.
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Profit is not the sole consideration for investors. They are perhaps more interested
in how much cash has been created through successful trading. This can be estimated
by adding back the depreciation (a non-cash cost) previously deducted in calculating
EBIT. This is termed earnings before interest, taxes, depreciation and amortisation
(amortisation is just a fancy name for depreciating intangible assets) or EBITDA. For
our company, this is:
EBITDA EBIT Depreciation
£22m £27m
£49 m
■
The cash flow statement
The third and final financial statement in a published set of accounts is the cash flow
statement. This statement is valuable because it reveals the main sources of cash and
how it has been applied. For Foto-U, the main two sources of cash during the year are
additional finance raised from new loans and net cash from operations (basically the
EBITDA referred to above plus a few other adjustments for non-cash items). The main
applications of this cash generated from trading are investment in capital expenditure,
and dividends. The final line on this statement shows that, during the year, cash has
increased by £7 million.
■
A financial health check using ratios
Accountants and bank managers have formulated dozens of financial ratios to help
diagnose the financial health of the business, its position, performance and prospects.
We shall restrict our focus to those key financial ratios that every finance manager and
investor should be acquainted with. These are summarised in Table 2.3 and discussed
briefly below.
Table 2.3
Foto-U key ratios
Ratio
Form
2006
2005
Profitability
Gross profit margin
Net profit margin
Return on capital employed (ROCE)
%
%
%
21.5
11.0
15.9
15.8
5.3
10.6
Activity ratios
Net asset turnover
Debtors
Stock
Supplier credit period
times
days
days
days
1.4
53
58
93
2.0
48
54
96
Liquidity and financing ratios
Current ratio
Quick (acid test) ratio
Gearing
Interest cover
times
times
%
times
1.1
0.7
43.5
11
0.9
0.5
24.5
5
Investor ratios
Return on shareholders’ funds
Dividend per share
Earnings per share
Dividend cover
Price:earnings
Dividend yield
%
pence
pence
times
times
%
17.9
3.5
7
2
17.1
2.9
5.6
1.5
2
1.3
25
3
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52 Part I A framework for financial decisions
Profitability ratios
To assess the performance of Foto-U, we study a number of profitability ratios.
Profit margin
This ratio shows how much profit is generated from every £ of sales. It can be considered in the form of a percentage at both the gross and net profit levels.
Gross profit margin
Gross profit
Sales
100 43
100
200
21.5%
115.8% last year2
Net profit margin
EBIT
22
100 100
Sales
200
11%
15.3% last year2
(EBIT is earnings before interest and tax, i.e. operating profit.)
Return on capital employed (ROCE)
This ratio, also termed the primary ratio, examines the rate of profit the business
makes on the long-term capital invested in it. Foto-U has shareholders’ funds of £78
million and long-term creditors of £60 million giving long-term capital of £138 million.
This is represented by the total assets less current liabilities figure on the balance sheet.
ROCE EBIT
22
100 100
Long-term capital
138
15.9%
110.6% last year2
Activity ratios
Here we examine how efficiently Foto-U manages its assets in terms of the level of
sales obtained from the assets invested.
Asset turnover
Sales
200
Total assets current liabilities
138
1.45 times
12 times last year2
This can also be expressed in terms of each type of asset, but here, we usually
express it in terms of days. For example, the average number of days it takes for
debtors to pay is given by debtor days.
Debtor days
Debtors
29
365 365
Credit sales
200
53 days
148 days last year2
Note also that we have used the asset figure at the year-end. A more accurate picture is given by finding the average asset value based on the values at the start and
end of the year.
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Similar calculations can be made for stock and creditors, but with one important difference. Stock and trade creditors are valued in the balance sheet at original cost so
instead of using sales, we use cost of sales, i.e., what it cost the firm to build these stocks.
Stockholding period
Stock
25
365 365
Cost of sales
157
154 days last year2
58 days
Supplier credit days
Trade creditors
40
365 365
Cost of sales
157
196 days last year2
93 days
It is preferable to use purchases rather than cost of sales, although this figure is not
always available.
Liquidity and Financing ratios
To assess whether the company is able to meet its financial obligations as they fall due,
we need to compare short-term assets with short-term creditors. Two such ratios are
commonly employed.
Current ratio
Current assets
66
Current liabilities
60
10.9 times last year2
1.1 times
Quick assets
For most firms, it is not easy to convert stock into cash with any great speed. The quick
assets (or acid-test ratio) is a more prudent liquidity ratio which excludes stock entirely.
Current assets stock
66 25
Current liabilities
60
0.7 times
10.5 times last year2
As a general rule-of-thumb, we would typically expect the current ratio to be 2 and
the quick assets to match creditors (i.e. a quick ratio of 1). However, this guide may
differ from industry to industry depending on the trade credit periods granted to customers and claimed from suppliers.
Gearing
A rather different question asks how the capital employed in the business is financed. The
gearing ratio shows the proportion of capital employed funded by long-term borrowings.
Long-term borrowings
Debt Equity capital
100 60
100
138
43.5%
124.5% last year2
An equally acceptable way of expressing the gearing ratio is by the Debt/Equity ratio.
Long-term borrowings
Shareholders’ funds
60
0.77:1
78
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54 Part I A framework for financial decisions
Interest cover
Another way of considering gearing is to look to the profit and loss account by assessing the degree of profits cover the firm has to meet its interest payments.
Earnings before interest and taxes
Interest payable
22
2
11 times 15 times last year2
An interest cover of 11 times is very safe. But were it to fall to, say, below three or
four, concern may arise that taxation and dividends cannot be paid.
Investor ratios
Shareholders are more interested in the return they obtain on their investment rather
than the return the company makes on the total business.
Return on shareholders’ funds (return on equity)
This indicates how profitable the company has been for its shareholders.
Earnings after tax and preference dividends
Shareholders’ funds
100 14
100
78
17.9%
15.6% last year2
Shareholders will also be interested in the earnings per share (what dividend could
be paid) and dividend per share (what dividend is paid) for the year.
Earnings per share (EPS)
Earnings after tax and preference dividends
Number of ordinary shares in issue
14
200
7 pence per share
12 pence last year2
In practice, the EPS calculation is usually more complex than this, but the notes to
the accounts will explain the calculation.
Dividend per share (DPS)
Total ordinary dividend
Number of ordinary shares in issue
7
200
3.5 pence per share
11.5 pence last year2
Dividend cover
This links the DPS and the EPS to indicate how many times the dividend could be paid,
and, hence, how safe it is, in terms of exposure to a fall in EPS.
Earnings per share
Dividend per share
7
3.5
2 times
11.3 times last year2
The final two ratios relate earnings and dividends to stock market performance as
reflected in the current share price. If the current share price for Foto-U is 120p, we can
calculate the price:earnings ratio and dividend yield.
Price:earnings ratio (P:E)
Current share price
Earnings per share
120
7
17.1 times
125 times last year2
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The share price, of course, is based on investors’ expectations of future profits. A
high P:E ratio indicates that investors expect future profits to grow – the higher the
P:E, the greater the profit growth expectation.
Dividend yield
Dividend per share 1p2
Share price 1p2
100 3.5
100
120
2.9%
13% last year2
In the UK, income tax at 10% is deducted at source, so the calculation should
therefore be based on the gross dividend.
■
Interpretation of the accounts and ratios
The financial manager or investor needs to put together all the clues suggested by ratio
analysis and reading the accounts to gain insights into the financial position, performance and prospects of the company. This will probably involve looking at the trend of
financial indicators, not simply comparison with the previous year, together with comparison with industry and competitor data. It certainly requires a reasonable grasp of
the business, its objectives and strategies. Table 2.4 offers a brief report to senior management of Foto-U by the finance manager on the company’s published accounts.
Table 2.4
Foto-U annual
corporate performance
report
To: Senior Management of Foto-U
From: Finance Manager
Subject: Annual corporate performance
30 April 2006
I have reviewed the published accounts for the past year to establish how successful
Foto-U was in financial terms.
Profitability. The Return on Capital Employed has improved over the year from 10.6%
to 16%. This is a significant improvement and well above the risk-free return we
would expect from investing in say building society deposits, but we need also to
compare the return against that achieved by our competitors. ROCE is a combination
of two subsidiary ratios – net profit margin and asset turnover:
ROCE
2005 10.6%
2006 15.9%
Net profit margin
5.3%
11%
Asset turnover
2 times
1.45 times
Both the gross and net profit margins have improved significantly as a result of the
£10 million growth in sales over the year without any increase in costs. However, this
growth has come at the expense of a poorer utilisation of our assets, as reflected in
the significant decline in asset turnover. This is mainly attributable to a major capital
expenditure programme during the year, the benefits of which will not be fully experienced for at least another year. A further factor is the increase in working capital.
Last year, we actually managed to have negative working capital (i.e. our trade creditors and overdraft financed more than our current assets). This year, there has been a
slight deterioration in all elements of working capital:
•
•
•
We take five more days to collect cash from customers
Stockholding period has increased by four days
We pay suppliers a little quicker.
Liquidity. Our current and quick asset ratios are both well below the typical level for
the industry of 1.8 and 1.0 respectively. However, this is largely due to the fact that
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56 Part I A framework for financial decisions
Table 2.4
Continued
our suppliers have been willing to grant us extended credit periods of about three
months. Realistically, we cannot expect this to continue. Were they to demand payment within say, 45 days, it is difficult to see where we would be able to find the
cash. It is not good financial management for us to rely on the generous credit of suppliers over whom we have no control, and we need to address this issue urgently.
Linked to this, we have just raised a large medium-term loan in order to fund our
capital expenditure in the coming year. Our gearing ratio has now nearly doubled
and we will have to find cash both for additional interest payments and, eventually,
the loan repayments. Unless the new investment very rapidly produces higher profits
and cashflow, I am concerned that we could be in serious financial difficulty, despite
the strong level of profits. Perhaps it is time to consider asking shareholders to invest
more capital in the business, or to reduce dividend payments.
Investment attractiveness. The company’s share price has progressed from 50 pence to
120 pence over the year. No doubt this is due to the growth in sales, profits and dividends in the year. Many of the investment performance indicators have improved,
particularly earnings per share and return on shareholders’ funds, the latter looking
much healthier at nearly 18%. However, the price:earnings ratio has slipped a little,
suggesting that investors do not expect the company’s profits and share price to continue to grow at quite the same rate as this year.
In summary, Foto-U has improved its performance over the past year, but there
remain concerns regarding its liquidity. Management is urged to give urgent attention to this matter.
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QUESTIONS
Questions with a coloured number have solutions in Appendix B on page 691.
1 When a company seeks a listing for its shares on a stock exchange, it usually recruits the assistance of a merchant bank.
(a) Explain the role of a merchant bank in a listing operation with respect to the various matters on which its
advice will be sought by a company.
(b) Identify the conflicts which might arise if the merchant bank were part of a group providing a wide range
of financial services.
(CIMA)
2 (a) Briefly outline the major functions performed by the capital market and explain the importance of each
function for corporate financial management. How does the existence of a well-functioning capital market assist the financial management function?
(b) Describe the Efficient Markets Hypothesis and explain the differences between the three forms of the
hypothesis which have been distinguished.
(c) Company A has 2 million shares in issue and company B 6 million. On day 1 the market value per share
is £2 for A and £3 for B. On day 2, the management of B decides, at a private meeting, to make a cash
takeover bid for A at a price of £3.00 per share. The takeover will produce large operating savings with a
value of £3.2 million. On day 4, B publicly announces an unconditional offer to purchase all shares of A
at a price of £3.00 per share with settlement on day 15. Details of the large savings are not announced and
are not public knowledge. On day 10, B announces details of the savings which will be derived from the
takeover.
Required
Ignoring tax and the time-value of money between days 1 and 15, and assuming the details given are the
only factors having an impact on the share prices of A and B, determine the day 2, day 4 and day 10 share
prices of A and B if the market is:
1 semi-strong form efficient, and
2 strong form efficient
in each of the following separate circumstances:
(i) the purchase consideration is cash as specified above, and
(ii) the purchase consideration, decided upon on day 2 and publicly announced on day 4, is one newly
issued share of B for each share of A.
(ACCA)
3 You are an accountant with a practice that includes a large proportion of individual clients, who often ask for
information about traded investments. You have extracted the following data from a leading financial newspaper.
Price
P:E ratio
Dividend yield (% gross)
(i) Stock
Buntam plc
160p
20
5
Zellus plc
270p
15
3.33
(ii) Earnings and dividend data for Crazy Games plc are given below:
EPS
Div. per share (gross)
1993
5p
3p
1994
6p
3p
1995
7p
3.5p
1996
10p
5p
1997
12p
5.5p
The estimated before tax return on equity required by investors in Crazy Games plc is 20%.
Continued
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58 Part I A framework for financial decisions
Required
Draft a report for circulation to your private clients which explains:
(a) the factors to be taken into account (including risks and returns) when considering the purchase of
different types of traded investments.
(b) the role of financial intermediaries, and their usefulness to the private investor.
(c) the meaning and the relevance to the investor of each of the following:
(i) Gross dividend (pence per share)
(ii) EPS
(iii) Dividend cover
Your answer should include calculation of, and comment upon, the gross dividends, EPS and dividend
cover for Buntam plc and Zellus plc, based on the information given above.
(ACCA)
4 Beta plc has been trading for twelve years and during this period has achieved a good profit record. To date,
the company has not been listed on a recognised stock exchange. However, Beta plc has recently appointed a
new chairman and managing director who are considering whether or not the company should obtain a full
Stock Exchange listing.
Required
(a) What are the advantages and disadvantages which may accrue to the company and its shareholders, of
obtaining a full stock exchange listing?
(b) What factors should be taken into account when attempting to set an issue price for new equity shares in
the company, assuming it is to be floated on a stock exchange?
(Certified Diploma)
5 Collingham plc produces electronic measuring instruments for medical research. It has recorded strong and
consistent growth during the past 10 years since its present team of managers bought it out from a large multinational corporation. They are now contemplating obtaining a stock market listing.
Collingham’s accounting statements for the last financial year are summarised below. Fixed assets, including freehold land and premises, are shown at historic cost net of depreciation. The debenture is redeemable
in two years although early redemption without penalty is permissible.
Profit and Loss Account for the year ended 31 December 1994 (£m)
Turnover
Cost of sales
Operating profit
Interest charges
Pre-tax profit
Corporation tax (after capital allowances)
Profits attributable to ordinary shareholders
Dividends
Retained earnings
80.0
(70.0)
10.0
(3.0)
7.0
(1.0)
6.0
(0.5)
5.5
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Balance Sheet as at 31 December 1994 (£m)
Assets employed
Fixed: Land and premises
Machinery
Current: Stocks
Debtors
Cash
Current liabilities: Trade creditors
Bank overdraft
Net current assets
Total assets less current liabilities
14% Debentures
Net assets
Financed by:
Issued share capital (par value 50p):
Voting shares
Non-voting ‘A’ shares
Profit and Loss Account
Shareholders’ funds
10.0
20.0
10.0
10.0
3.0
(15.0)
(5.0)
30.0
23.0
(20.0)
3.0
33.0
(5.0)
28.0
2.0
2.0
24.0
28.0
The following information is also available regarding key financial indicators for Collingham’s industry.
Return on (long-term) capital employed
Return on equity
Operating profit margin
Current ratio
Acid test
Gearing (total debt/equity)
Interest cover
Dividend cover
P:E ratio
22% (pre-tax)
14% (post-tax)
10%
1.8:1
1.1:1
18%
5.2
2.6
13:1
Required
(a) Briefly explain why companies like Collingham seek stock market listings.
(b) Discuss the performance and financial health of Collingham in relation to that of the industry as a whole.
(c) In what ways would you advise Collingham:
(i) to restructure its balance sheet prior to flotation?
(ii) to change its financial policy following flotation?
Practical assignment
Select two companies from one sector in the Financial Times share information service. Analyse the share price
and other data provided and compare this with the FT All-Share Index data for the sector. Suggest why the P:E
ratios for the companies differ.
59
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60 Part I A framework for financial decisions
3
Present values and financial arithmetic
An investment parable
A man, going off to another country, called together his
servants and loaned them money to invest for him
while he was gone. He gave £500 to one, £200 to
another and £100 to the last – dividing it in proportion
to their abilities – and then left on his trip. The man
who received the £500 began immediately to buy and
sell with it and soon earned another £500. The man
with £200 went right to work, too, and earned another
£200. But the man who received the £100 dug a hole
in the ground and hid the money for safe keeping.
After a long time their master returned from his
trip and called them to him to account for his
money. The man to whom he had entrusted the £500
brought him £1,000. His master praised him for good
work. ‘You have been faithful in handling this small
amount,’ he told him, ‘so now I will give you many
more responsibilities.’ Next came the man who had
received £200, with the report, ‘Sir, you gave me
£200 to use, and I have doubled it.’ ‘Good work’, his
master said. ‘You have been faithful over this small
amount, so now I will give you much more.’
Then the man with the £100 came and said, ‘Sir,
I knew you were a hard man, and I was afraid you
would rob me of what I earned, so I hid your money
in the earth and here it is!’
But his master replied, ‘You lazy rogue! Since you
knew I would demand your profit, you should at least
have put my money into the bank so I could have
some interest.’
Source: Matthew, Chapter 25, Living Bible.
Learning objectives
Having completed this chapter, you should have a sound grasp of the time-value of money and discounted cash flow concepts. In particular, you should understand the following:
■
The time-value of money.
■
The financial arithmetic underlying compound interest and discounting.
■
Present value formulae for single amounts, annuities, perpetuities and bonds.
■
The net present value approach and why it is consistent with shareholder goals.
Skills developed in discounted cash flow analysis, using both formulae and tables, will help enormously
in subsequent chapters.
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3.1
61
INTRODUCTION
The introductory investment parable, taken from business life in 1st century Palestine,
is equally appropriate to present times. Managers are expected to make sound longterm decisions and to manage resources in the best interests of the owners. To do otherwise is to risk the wrath of an unmerciful stock market! Rather like the lazy servant
in the parable, Eurotunnel put the £10 billion entrusted to it by shareholders and
bankers into a ‘hole in the ground’ stretching from Dover to Calais. From an investment
perspective they would have done better letting it earn interest in a bank.
To assess whether investment ideas are wealth-creating, we need to have a clear
understanding of cash flow and the time-value of money. Capital investment decisions, security and bond value analyses, financial structure decisions, lease vs. buy
decisions and the tricky question of the required rate of return can be addressed only
when you understand exactly what the old expression ‘time is money’ really means.
In this chapter we will consider the measurement of wealth and the fundamental
role it plays in the decision-making process; the time-value of money, which underlies
the discounted cash flow concept; and the net present value approach for analysing
investment decisions.
3.2
MEASURING WEALTH
‘Cash flow is King’ seems to be the message for businesses today. Spectacular business
collapses in recent years demonstrate that reliance on profits or earnings per share as
measures of performance can be dangerous.
The chairman of a fast-growing company that went out of business stated in the
annual report: ‘Last year, we delivered a 425% increase in turnover from £19.9 million
to £109.8 million.’ But when the firm was placed into the hands of the receiver the following year, it was not the lack of sales or even profits that put it there. It was the lack
of cash. Businesses go ‘bust’ because they run out of the cash required to fulfil their
financial obligations. Of course, there are always reasons why this happens – recession,
an over-ambitious investment programme, rapid growth without adequate long-term
finance – but basically corporate survival and success come down to cash flow and
value creation.
Boo.com, the internet fashion retailer, thought it had a promising future at the start
of 2000. It had raised $135 million to set up the new business and invest in marketing
to break into the competitive fashion retail sector. But less than six months later, it had
virtually run out of cash and was forced into liquidation.
Recall from Chapter 1 that the assumed objective of the firm is to create as much
wealth as possible for its shareholders. A successful business is one that creates value
for its owners. Wealth is created when the market value of the outputs exceeds the
market value of the inputs, i.e. the benefits are greater than the costs. Expressed
mathematically:
Vj Bj Cj
time-value of money
Money received in the future is
usually worth less than today
because it could be invested to
earn interest over this period
The value (Vj) created by decision j is the difference between the benefits (Bj) and
the costs (Cj) attributable to the decision. This leads to an obvious decision rule: accept
only those investment or financing proposals that enhance the wealth of shareholders,
i.e. accept if Bj Cj 0.
Nothing could be simpler in concept – the problems emerge only when we probe
more deeply into how the benefits and costs are measured and evaluated. One obvious problem is that benefits and costs usually occur at different times and over a number of years. This leads us to consider the time-value of money.
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Boo.com collapses as investors refuse funds
Boo.com, the online sportswear retailer, last night became Europe’s first big internet casualty when the
refusal of its backers to continue funding its heavy losses forced it into liquidation. The company – one of
the highest profile internet retailers in Europe – appointed KPMG as liquidator, having spent all but
$500,000 of the $135 million it had raised since early last year.
Boo’s founders, including former model Kajsa Leander and Ernst Malmsten, chief executive, own about
40 per cent of the equity. Ernst Malmsten said last night: ‘It could be a big blow for the internet in
Europe and frighten investors from investing in start-ups because they could lose their reputation as well
as their funding. We have been too visionary. We wanted everything to be perfect, and we have not had
control of costs. My mistake has been not to have a counterpart who was a strong financial controller’.
After a high-profile launch, the company was dogged by technical problems that delayed the site going
live by five months. Boo needed $430 million to implement an emergency restructuring plan that would
have seen redundancies among the 300-strong workforce and closure of some overseas offices. But
investors were not prepared to back the plan with more money.
Source:Based on Financial Times, 18 May 2000.
3.3 TIME-VALUE OF MONEY
An important principle in financial management is that the value of money depends on
when the cash flow occurs – £100 now is worth more than £100 at some future time. There
are a number of reasons for this:
1 Risk. One hundred pounds now is certain, whereas £100 receivable next year is less certain. This ‘bird-in-the-hand’ principle affects many aspects of financial management.
2 Inflation. Under inflationary conditions, the value of money, in terms of its purchasing power over goods and services, declines.
3 Personal consumption preference. Most of us have a strong preference for immediate
rather than delayed consumption.
More fundamental than any of the above, however, is the time-value of money.
Money – like any other desirable commodity – has a price. If you own money, you can
‘rent’ it to someone else, say a banker, and earn interest. A business which carries
unnecessarily high cash balances incurs an opportunity cost – the lost opportunity to
earn money by investing it to earn a higher return. The overall investor’s return, which
reflects the time-value of money, therefore comprises:
(a) the risk-free rate of return rewarding investors for forgoing immediate consumption, plus
(b) compensation for risk and loss of purchasing power.
Self-assessment activity 3.1
Imagine you went to your bank manager asking for a £50,000 loan, for five years, to start
up a burger bar under a McDonald’s franchise. Which of the considerations in the previous
paragraph would the bank manager consider?
(Answer in Appendix A at the back of the book)
Before proceeding further, we need to understand the essential financial arithmetic
for the time-value of money. This will stand readers in good stead not only in
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63
analysing capital and financial investments in the remainder of this book, but also in
handling their personal finances. For example, it will provide a better understanding
of how interest is calculated for credit cards, bank loans, repayment mortgages and
hire purchase arrangements.
3.4
■
FINANCIAL ARITHMETIC FOR CAPITAL GROWTH
Simple and compound interest
The future value (FV) of a sum of money invested at a given annual rate of interest
will depend on whether the interest is paid only on the original investment (simple
interest), or whether it is calculated on the original investment plus accrued interest
(compound interest). Suppose you win £1,000 on the National Lottery and decide to
invest it at 10 per cent for five years, simple interest. The future value will be the original £1,000 capital plus five years’ interest of £100 a year, giving a total future value
of £1,500.
With compound interest, the interest is paid on the original capital plus accrued
interest, as shown in Table 3.1. The process of compounding provides a convenient
way of adjusting for the time-value of money. An investment made now in the capital
market of Vo gives rise to a cash flow of Vo(1 i)2 after two years, and so on. In general, the future value of Vo invested today at a compound rate of interest of i per cent
for n years will be:
FV(i,n) = Vo(1 + i)n
where FV(i,n) is the future value at time n, Vo is the original sum invested, sometimes
termed the principal (note that the o subscript refers to the time period, i.e. today), and
i is the annual rate of interest.
Using this formula in the above example we obtain the same future value as in
Table 3.1.
FV5 £1,000(1 0.10)5 £1,610
Note that the effect of compound interest yields a higher value than simple interest,
which yielded only £1,500.
■
More frequent compounding and annual percentage rates
Unless otherwise stated, it is assumed that compounding or discounting is an annual
process; cash payments of benefits arise either at the start or the end of the year.
Frequently, however, the contractual payment period is less than one year. Building
societies and government bonds pay interest semi-annually or quarterly. Interest
charged on credit cards is applied monthly. To compare the true costs or benefits of such
financial contracts, it is necessary to determine the annual percentage rate (APR), or
effective annual interest rate.
Table 3.1
Compound interest on
£1,000 over five years
(at 10%)
Year
1
2
3
4
5
Starting
balance £
1000
1100
1210
1331
1464
Interest £
100
110
121
133
146
Closing
Balance £
1100
1210
1331
1464
1610
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64 Part I A framework for financial decisions
Returning to our earlier example of £1,000 invested for five years at 10 per cent compound interest, we now assume 5 per cent payable every six months.
After the first six months, the interest is £50, which is reinvested to give interest for
the second half year of (£1,050 5%) £52. The end-of-year value is therefore (£1,050
£52) £1,102. We can still use the compound interest formula, but with i as the sixmonthly interest rate and n the six-monthly, rather than annual, interval:
After 1 year, FV1 £1,00011 0.052 2
£1,102
After 5 years, FV5 £1,00011 0.052 10
£1,629
Note that this value is higher than the £1,610 value based on the earlier annual interval calculation. In converting the annual compounding formula to another interest
payment frequency, the trick is simply to divide the annual rate of interest (i) and multiply the time (n) by the number of payments each year.
If, in the above example, interest is calculated at weekly intervals over five years,
the future value will be:
FV5 £1,000 ¢1 0.10 52152
£1,648
≤
52
Taking compounding to its limits, we can adopt a continuous discounting
approach.*
Table 3.2 calculates the APRs based on a range of interest payment frequencies for
a 22 per cent per annum loan. By charging compound interest on a daily basis, the
effective annual rate is 24.6 per cent, some 2.6 per cent higher than on an annual basis.
It is now a legal requirement for many financial contracts that the lender clearly states
the APR.
Table 3.2
Annual percentage
rates for a loan with
interest payable at 22
per cent per annum
Annually
11 0.222
Semi-annually
¢1 Quarterly
1
0.22 or 22%
0.22 2
≤
2
1
0.232 or 23.2%
¢1 0.22 4
≤
4
1
0.239 or 23.9%
Monthly
¢1 0.22 12
≤ 1
12
0.244 or 24.4%
Daily
¢1 0.22 365
≤ 1
365
0.246 or 24.6%
*When the number of compounding periods each year approaches infinity, the future value is found by:
FVn Voe in
where i is the annual interest rate, n is the number of years and e is the value of the exponential
function. Using a scientific calculator, this is shown as 2.71828 (to five decimal places).
Using the same example as before:
FV4 Voe in £1,000 e 10.125
£1,648.72 1slightly more than compounding on a weekly basis2
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3.5
65
PRESENT VALUE
present value
The current worth of future
cash flows
discounting
The process of reducing cash
flows to present values
An alternative way of assessing the worth of an investment is to invert the compounding process to give the present value of the future cash flows. This process is called
discounting.
The time-value of money principle argues that, given the choice of £100 now or the
same amount in one year’s time, it is always preferable to take the £100 now because
it could be invested over the next year at, say, a 10 per cent interest rate to produce £110
at the end of one year. If 10 per cent is the best available annual rate of interest, then
one would be indifferent to (i.e. attach equal value to) receiving £100 now or £110 in
one year’s time. Expressed another way, the present value of £110 received one year
hence is £100.
We obtained the present value (PV) simply by dividing the future cash flow by 1
plus the rate of interest, i, i.e.
PV £110
£110
£100
11 0.102
11.12
Discounting is the process of adjusting future cash flows to their present values. It is,
in effect, compounding in reverse.
Recall that earlier we specified the future value as:
FVn Vo 11 i2 n
Dividing both sides by 11 i2 n we find the present value:
Vo FVn
11 i2 n
which can be read as the present value of future cash flow FV receivable in n years’ time
given a rate of interest i. This is the process of discounting future sums to their present
values.
Let us apply the present value formula to compute the present value of £133 receivable three years hence, discounted at 10 per cent:
PV110%, 3 yrs2 £133
£133
£100
3
1.33
11 0.102
The message is: do not pay more than £100 today for an investment offering a certain return of £133 after three years, assuming a 10 per cent market rate of interest.
Calculator tip
Your calculator should have a power function key, usually xy. Try the following steps for
the previous example.
Input
Press
Input
Press
Display
Press
Multiply
Press
Answer
1.1
xy function key
3
1.331
1/x
133
99.9
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66 Part I A framework for financial decisions
Self-assessment activity 3.2
Calculate the present value of £623 receivable in eight years’ time plus £1,092 receivable
eight years after that, assuming an interest rate of 7 per cent.
(Answer in Appendix A at the back of the book)
■
Discount tables
Much of the tedium of using formulae and power functions can be eased by using discount tables or computer-based spreadsheet packages. In the previous example, the
discount factor for £1 for a 10 per cent discount rate in three years’ time is:
1
1
0.751
3
1.33
11.102
This can be found in Appendix C by locating the 10 per cent column and the 3 year
row. We call this the present value interest factor (PVIF) and express it as PVIF110%, 3 yrs2
or PVIF110,32.
Multiplying the cash flow of £133 by the discount factor yields the same result as
before:
PV £133 0.751 £100 1subject to rounding2
annuity
A constant annual cash flow
for a prescribed period of time
With a constant annual cash flow, termed an annuity, we can shorten the discounting operation. Appendix D provides the present value interest factor for an annuity
(PVIFA). Thus, if £133 is to be received in each of the next three years, the present value
is:
PV £133 PVIFA110%, 3 yrs2
£133 2.4868 £331
It is standard practice to write interest factors as: Interest factor(rate, period).
Examples:
PVIF18,102 is the present-value interest factor at 8 per cent for ten years.
PVIFA110,42 is the present-value interest factor for an annuity at 10 per cent for four
years.
Example of present values: Soldem Pathetic plc
Soldem Pathetic Football Club has recently been bought up by a wealthy businessman who intends to return the club to its former glory days. He also wants to pay a
good dividend to the shareholders of the newly-formed quoted company by making
sound investments in quality players. One such player the manager would dearly
like in his squad is Bryan Riggs, currently on the market for around £9 million. The
chairman reckons that, quite apart from the extra income at the turnstiles from buying him, he could be sold for £11 million by the end of the year, given the way transfer prices are moving. Should he bid for Riggs?
Assuming a 10 per cent rate of interest as the reward that the other shareholders
demand for accepting the delayed payoff, the present value (PV) of £11 million receivable one year hence is:
PV discount factor future cash flow £10 million
1
£11 million
1.10
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Chapter 3 Present values and financial arithmetic
67
How much better off will the club be if it buys Riggs? The answer is, in present value
terms:
£10 million £9 million £1 million
net present value
The present value of
the future net benefits
less the initial cost
We call this the net present value (NPV). The decision to buy the player makes economic sense; it promises to create wealth for the club and its shareholders, even
excluding the likely additional gate receipts. Of course, Riggs could break a leg in the
very first game for his new club and never play again. In such an unfortunate situation, the club would achieve a negative NPV of £9 million, the initial cost.
Alternatively, he could be insured against such injury, in which case there would be
premiums to pay, resulting in a lower net present value.
Another way of looking at this issue is to ask whether the investment offers a return
greater than could have been achieved by investing in financial, rather than human,
assets. The return over one year from acquiring Riggs’ services is:
Return £11 m £9 m
Profit
100 22.2%.
investment
£9 m
If the available rate of interest is 10 per cent, the investment in Riggs is a considerably
more rewarding prospect.
In the highly simplified example above, we assumed that the future value was certain and the interest rate known. Of course, a spectrum of interest rates is listed in the
financial press.
This variety of rates arises predominantly because of uncertainty surrounding the
future and imperfections in the capital market. To simplify our understanding of the
time-value of money concept, let us ‘assume away’ these realities. The lender knows
with certainty the future returns arising from the proposal for which finance is sought,
and can borrow or lend on a perfect capital market. The latter assumes the following:
1 Relevant information is freely available to all participants in the market.
2 No transaction costs or taxes are involved in using the capital market.
3 No participant (borrower or lender) can influence the market price for funds by the
scale of its activities.
4 All participants can lend and borrow at the same rate of interest.
Under such conditions, the corporate treasurer of a major company like Shell can
raise funds no more cheaply than the chairman of Soldem Pathetic. A single market
rate of interest prevails. Borrowers and lenders will base time-related decisions on this
unique market rate of interest. The impact of uncertainty will be discussed in later
chapters; for now, these simplistic assumptions will help us to grasp the basics of
financial arithmetic.
■
The effect of discounting
Figure 3.1 shows how the discounting process affects present values at different rates
of interest between 0 and 20 per cent. The value of £1 decreases very significantly as the
rate and period increase. Indeed, after 10 years, for an interest rate of 20 per cent, the
present value of a cash flow is only a small fraction of its nominal value.
Table 3.3 summarises the discount factors for three rates of interest. It is useful to
develop a ‘feel’ for how money changes with time for these rates of interest. The 15 per
cent discount rate is particularly useful, because investment surveys (e.g. Pike 1988)
suggest that this is a popular discount rate for evaluating capital projects. It also happens to be easy to remember: every five years the discounted value halves. Thus, with
a 15 per cent discount rate, after five years the value of £1 is 50p, after 10 years 25p, etc.
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68 Part I A framework for financial decisions
0%
Figure 3.1
Present value of £1
1.00
0.75
5%
10%
0.50
15%
20%
0.25
The relationship
between present value
of £1 and interest over
time
0
2
4
6
Periods
8
10
Table 3.3
Present value of a single
future sum
Year
10%
15%
20%
0
5
10
15
20
25
£1.00
0.60
0.40
0.24
0.15
0.09
£1.00
0.50
0.25
0.12
0.06
0.03
£1.00
0.40
0.16
0.06
0.03
0.01
Self-assessment activity 3.3
Your company is just about to sign a deal to purchase a fleet of lorries for £1 million. The
payment terms are £500,000 down payment and £500,000 at the end of five years. No
one present has a calculator or discount tables to hand. If the cost of capital for the company is 15 per cent, what is the present value cost of the purchase?
(Answer in Appendix A at the back of the book)
3.6
PRESENT VALUE ARITHMETIC
We have seen that the present value of a future cash flow is found by multiplying the
cash flow by the present value interest factor. The present value concept is not difficult
to apply in practice. This section explains the various present value formulae, and illustrates how they can be applied to investment and financing problems. Throughout, we
shall use the symbol X to denote annual cash flow in pounds and i to denote the interest, or discount, rate (expressed as a percentage). Recall that PVIF is the present value
interest factor and PVIFA is the PVIF for an annuity.
■
Present value
We know that the present value of X receivable in n years is calculated from the
expression:
PV1i,n2 Xn
11 i2 n
X times PVIF1i,n2
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Chapter 3 Present values and financial arithmetic
69
Example
Calculate the present value of £1,000 receivable in 10 years’ time, assuming a discount
rate of 14 per cent:
PVIF114%, 10 yrs2 1
0.26974
11.142 10
Alternatively, the table in Appendix C provides PVIF of 0.26974 for n 10 and
i 14 per cent:
PV £1,000 0.26974 £269.74
The present value of £1,000 receivable ten years hence, discounted at 14 per cent, is
thus £269.74.
Self-assessment activity 3.4
Calculate the present value of £1,000 receivable 12 years hence, assuming the discount
rate is 12 per cent.
(Answer in Appendix A at the back of the book)
■
Valuing perpetuities
perpetuity
A constant annual cash flow
for an infinite period of time
Frequently, an investment pays a fixed sum each year for a specified number of years.
A series of annual receipts or payments is termed an annuity. The simplest form of
annuity is the infinite series or perpetuity. For example, certain government stocks offer
a fixed annual income, but there is no obligation to repay the capital. The present value
of such stocks (called irredeemables) is found by dividing the annual sum received by
the annual rate of interest:
PV perpetuity X
i
Example
Uncle George wishes to leave you in his will an annual sum of £10,000 a year, starting
next year. Assuming an interest rate of 10 per cent, how much of his estate must be set
aside for this purpose? The answer is:
PV perpetuity £10,000
£100,000
0.10
Suppose that your benevolent uncle now wishes to compensate for inflation, estimated to be at 5 per cent per annum. The formula can be adjusted to allow for growth
at the rate of g per cent p.a. in the annual amount. (The derivation of the present value
of a growing perpetuity is found in Appendix II at the end of the chapter.)
PV X
ig
As long as the growth rate is less than the interest rate, we can compute the present
value required:
PV £10,000
£200,000
0.10 0.05
This formula plays a key part in analysing financial decisions and will be developed
further in Chapter 4, when we consider the valuation of assets, shares and companies.
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70 Part I A framework for financial decisions
■
Valuing annuities
An annuity is an investment paying a fixed sum each year for a specified period of
time. Examples of annuities are many credit agreements and house mortgages.
The life of an annuity is less than that of a perpetuity, so its value will also be somewhat less. In fact, the formula for calculating the present value of an annuity of £A is
found by calculating the present value of a perpetuity and deducting the present value
of that element falling beyond the end of the annuity period. This gives the somewhat
complicated formula (see Appendix II at the end of chapter for the derivation) for the
present value of an annuity (PVA):
1
1
PVA1i,n2 A¢ ≤
i
i11 i2 n
A PVIFA1i,n2
In words, the present value of an annuity for n years at i per cent is the annual sum
multiplied by the appropriate present value interest factor for an annuity.
Suppose an annuity of £1,000 is issued for 20 years at 10 per cent. Using the table in
Appendix D, we find the present value as follows:
PVA110%, 20 yrs2 £1,000 PVIFA110,202
£1,000 8.5136 £8,513.60
Self-assessment activity 3.5
Calculate the present value of £250 receivable annually for 21 years plus £1,200 receivable after 22 years, assuming an interest rate of 11 per cent.
(Answer in Appendix A at the back of the book)
■
Calculating interest rates
Sometimes, the present values and future cash flows are known, but the rate of interest
is not given. A credit company may offer to lend you £1,000 today on condition that you
repay £1,643 at the end of three years. To find the compound rate of interest on the loan,
we solve the present value formula for i:
PV1i,n2 PVIF1i,n2 FV
Rearranging the formula,
PVIF1i,32 internal rate of return
The rate of return that equates
the present value of future cash
flows with initial investment
outlay
£1,000
PV
0.60864
FV
£1,643
Turning to the tables in Appendix C and looking for 0.6086 under the year 3 column, we find the rate of interest is 18 per cent. As we shall see in Chapter 5, this calculation is fundamental to investment and finance decisions and is termed the internal
rate of return.
It is also possible to solve the present value formula for i:
PV FV
11 i2 n
11 i2 n FV>PV
i 1FV>PV2 1>n 1
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Chapter 3 Present values and financial arithmetic
71
In the above example:
i 11,643>1,0002 1>3 1 0.18 or 18%
Who wants to be a millionaire?
An advertisement in the financial press read: ‘How to become a millionaire? Invest £9,138
in the M&G Recovery unit trust in 1969 and wait for 25 years.’ So, for those of us who
missed out on this investment, let us grudgingly calculate its annual return:
i 1FV>PV2 1>n 1
1£1 million>£9,1382 1>25 1
20.66%
By investing in a unit trust earning an annual rate of return of around 21 per cent,
£9,138 turns you into a millionaire in 25 years’ time. All you have to do is find an
investment giving 21 per cent for 25 years!
3.7
VALUING BONDS
DCF has long been used to help value financial securities. We consider share valuation
in the next chapter, but deal here with the valuation of bonds. A bond is a long-term
loan which promises to pay interest and repay the loan in accordance with the agreed
terms. Governments, local authorities, companies and other organisations frequently
seek to raise funds by issuing bonds, sometimes termed loan stock.
Once issued, bonds are traded in the secondary bond markets. Although a bond has
a par, or nominal, value – typically £100 – its actual value will vary according to the
cash flows it pays (interest and repayments) and the prevailing rate of interest for this
type of bond. The fair price is the present value of the future interest and repayments.
Vo PV 1interest payments2 PV 1redemption value2
Coupon rate
The nominal annual rate of
interest expressed as a percentage of the principal value
discount
The amount below the face
value of a financial instrument
at which it sells
premium
Bondo Ltd issues a two-year bond with a 10 per cent coupon rate and interest
payable annually. The bond is priced at its face value of £100:
£100 £10 £100
£10
1.10
11.102 2
The bond value above includes the present value of the first year’s interest plus the
present value of the two elements of the Year 2 cash flow (i.e. interest and redemption
value).
Assume that the interest rate unexpectedly rises to 12 per cent. The bond is now
priced in the secondary market at a discount at the lower value of £96.62, reflecting the
fact that the 10 per cent interest rate is now less attractive to investors:
£96.62 £10
£10 £100
1.12
11.122 2
Assume now that the interest rates fall to 8 per cent. The bond would now be
viewed as more attractive and lead it to be priced at a premium:
The amount above the face
value of a financial instrument
at which it sells
£103.57 £10
£10 £100
1.08
11.082 2
From the above we may conclude that bonds will sell:
■
■
at a discount where the coupon rate is below the market interest rate, and
at a premium where the coupon rate is above the market interest rate.
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72 Part I A framework for financial decisions
yield to maturity
The interest rate at which the
present value of the future
cash flows equals the current
market price
■
In the above example, the market interest was known. It may be that we know the bond
prices and wish to calculate the yield to maturity. Here we use the same formula but
the unknown is the interest rate. Thus, in the above where the market price is £103.57
we solve the equation (using a computer or trial and error) to find that 8 per cent is the
yield to maturity. The bond has a 10 per cent coupon and is priced at £103.57 to yield 8
per cent.
Valuing a bond in Millie Meter plc
Some time ago you purchased an 8 per cent bond in the fashion chain, Millie Meter.
Today, it has a par value of £100 and two years to maturity. Interest is payable halfyearly. What is it worth?
Assuming the current comparable rate of interest is 8 per cent, the value should
equal the par value of £100.
Vo 4
4
4
100
4
£100
2
3
4
11.042
11.042
11.042
11.042
11.042 4
Notice that because payments are made half-yearly, both the interest and discount
rate are half the annual figures.
In reality, the required rate of return demanded by investors may be different from
the original coupon rate. Let us say it is 10 per cent. As this is higher than the coupon
rate, the bond value for Millie Meter will fall below its par value:
Vo 4
4
4
4
100
£96.45
2
3
4
11.052
11.052
11.052
11.052
11.052 4
This example shows that an investor would have to pay £96.45 for a bond offering
a 4 per cent coupon rate (i.e. based on the par value of £100) plus the redemption
value in two years’ time, assuming that the market rate of interest for this security is
10 per cent.
For actively traded bonds there is little need to value them in this way because, if
the bond market is efficient, it has already done it for you. All you need do is to look
at the latest quoted price. However, the required rate of return is less easy to obtain.
Who says, in the above example, that 10 per cent is the return expected by the market
for this type of bond? The answer is simple. If we know the current bond price, we put
this in the above equation to find that discount rate which equates price with the discounted future cash flows – 10 per cent in the previous example.
Back to the future
‘Tis the season to be jolly but there’s
always someone to cry ‘Humbug’.
According to Guy Monson from Saracen
Investment Fund in London, things are
pretty much as they were back in 1843
when Charles Dickens gave the world
Ebenezer Scrooge, miser extraordinaire,
in his novel A Christmas Carol.
Interest rates, government bond yields
and inflation are all within a whisker of
where they stood 141 years ago. There’s
also much living beyond one’s means:
FT
that exercised Scrooge then and worries
analysts now.
If that wasn’t enough, some things have
actually got worse since the days of poverty
that Dickens so savagely chronicled. Back
then, income tax stood at just 5 per cent.
As old Ebenezer so charmingly put it:
‘Every idiot who goes around with Merry
Christmas on his lips should be buried
with his own pudding.’
Source: Financial Times, 23 December 2004, p. 12
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■
73
Factors affecting interest rates
term structure of interest
rates
Pattern of interest rates on
bonds of the same risk with
different lengths of time to
maturity
3.8
It is common in financial management to talk about the interest rate ruling in the
money market. However, it is important to realise that there is never a single prevailing rate. At any time, there is a spectrum of interest rates on offer – along this spectrum
the rates depend on the identity of the borrower e.g. firm or government, and hence,
the degree of risk faced by the lender, the amount lent or borrowed and the period over
which the loan is made available. The last of these aspects is referred to as the term
structure of interest rates. This shows how the yields offered for loans of different
maturities vary as the term of the loan increases. We discuss this, together with the
Yield Curve, in Appendix I to this chapter.
NET PRESENT VALUE
We have assumed that the paramount objective of the firm is to create as much wealth as
possible for its owners through the efficient use of existing and future resources. To create wealth, the present value of all future cash inflows must exceed the present value of
all anticipated cash outflows. Quite simply, an investment with a positive net present value
increases the owners’ wealth. The elements of investment appraisal are shown in Figure 3.2.
Most decisions involve both costs and benefits. Usually, the initial expenditure
incurred on an investment undertaken is clear-cut: it is what we pay for it. This
includes the cash paid to the supplier of the asset plus any other costs involved in
making the project operational. The problems start in measuring the worth of the
investment project. What an asset is worth may have little to do with what it cost or
what value is placed on it in the firm’s Balance Sheet. A machine standing in the firm’s
books at £20,000 may be worth far more if it is essential to the manufacture of a highly profitable product, or far less than this if rendered obsolete through the advent of
new technology. To measure its worth, we need to consider the value of the current and
Increase shareholder value
Goal
Inputs
Annual cash flow
(Xt )
Cost of capital
(K )
Financial analysis
Discount cash flows at the cost of capital
to find net present value
NPV signal
Figure 3.2
Investment appraisal
elements
Decision outcome
+
–
ACCEPT
REJECT
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74 Part I A framework for financial decisions
future benefits less costs arising from the investment. Wherever possible, these benefits
should be expressed in terms of cash flows. Sometimes (as will be discussed later) it is
impossible to quantify benefits so conveniently. Typically, investment decisions
involve an initial capital expenditure followed by a stream of cash receipts and disbursements in subsequent periods. The net present value (NPV) method is applied to
evaluate the desirability of investment opportunities. NPV is defined as:
NPV X3
Xn
X1
X2
p
I
2
3
11 k2
11 k2 n
11 k2
11 k2
which may be summarised as:
n
Xt
NPV a
t I
t1 11 k2
where Xt is the net cash flow arising at the end of year t, I is the initial cost of the investment, n is the project’s life, and k the minimum required rate of return on the investment (or discount rate). (The Greek letter ©, or sigma, denotes the sum of all values in
a particular series.)
Note that we have introduced a subtle change in notation, replacing i, which denoted the general market rate of interest, by k, which refers to the rate of return that must
be achieved by the firm in question. As we shall see, k may vary significantly from firm
to firm.
A project’s net present value (NPV) is determined by summing the net annual cash
flows, discounted at a rate that reflects the cost of an investment of equivalent risk on
the capital market, and deducting the initial outlay.
Self-assessment activity 3.6
Define the main elements in the capital investement decision.
(Answer in Appendix A at the back of the book)
The net present value rule
Wealth is maximised by accepting all projects that offer positive net present values
when discounted at the required rate of return for each investment.
Most of the main elements in the NPV formula are largely externally determined.
For example, in the case of investment in a new piece of manufacturing equipment,
management has relatively little influence over the price paid, the life expectancy or
the discount rate. These elements are determined, respectively, by the price of capital
goods, the rate of new technological development and the returns required by the capital market. Management’s main opportunity for wealth creation lies in its ability to
implement and manage the project so as to generate positive net cash flows over the
project’s economic life.
■
An NPV example: Gazza Ltd
The management of Gazza Ltd is currently evaluating an investment in hair dye products costing £10,000. Anticipated net cash inflows are £6,000 received at the end of year
1 and a further £6,000 at the end of year 2. Assuming a discount rate of 10 per cent, calculate the project’s net present value.
We can compute the NPV for Gazza using three different approaches, all of which
will be employed in later chapters.
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Chapter 3 Present values and financial arithmetic
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1 Formula approach
NPV £6,000
£6,000
£10,000
1.1
11.12 2
£5,454 £4,959 £10,000
£413
This approach is particularly useful with few cash flows or where discount factors
are not available in tables.
2 Present value tables (using Appendix C)
Year
Cash flow £
1
2
6,000
6,000
Discount factor at 10%
0.90909
0.82645
1.73554
Less initial cost
NPV
Present value £
5,454
4,959
10,413
(10,000)
413
3 Present value annuity tables (using Appendix D)
NPV 1£6,000 PVIFA110,22 2 £10,000
1£6,000 1.73552 £10,000
£413
This approach is appropriate only when annual cash flows are constant. Notice that
the present-value interest factor for an annuity at 10 per cent for two years (taken
from Appendix D) is simply the cumulative total of the individual factors in the previous approach.
How would the net present value differ if the perceived project risk were greater?
The risk-averse management of Gazza would probably require a higher return from
the project, reflected in a higher discount rate. Let us repeat the exercise using 13 per
cent (average risk) and 16 per cent (high risk).
Using 13 per cent:
NPV 1£6,000 PVIFA113,22 2 £10,000
1£6,000 1.66812 £10,000
£8 1i.e. approximately zero2
Using 16 per cent:
NPV 1£6,000 1.60522 £10,000
13692
Looking at the net present values, what interpretation can be made? With a 10 per
cent discount rate, the project offers a positive NPV of £413. If the projected cash flows
are generally expected to be achieved, the market value of the firm should rise by £413.
Hence, the project should be accepted. On the other hand, if the project is classified as
high risk, the cash inflows are discounted at a rate of 16 per cent and the NPV is estimated at £369. Its acceptance would reduce the firm’s market value by £369. Hence,
the project should not be accepted. Clearly, it would not be wise to exchange £10,000
today for future cash flows having a present value of less than this amount.
If the project is classified as having average risk, the discount rate used is 13 per
cent, yielding an NPV of £8. The project is just acceptable; it yields 13 per cent, which
is the required rate of return. We can draw two important conclusions:
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76 Part I A framework for financial decisions
1 Project acceptability depends upon cash flows and risk.
2 The higher the risk of a given set of expected cash flows (and the higher the discount rate), the lower will be its present value. In other words, the value of a given
expected cash flow decreases as its risk increases.
■
Why NPV makes sense
In Appendix II to this chapter, we examine more rigorously the rationale for the NPV
approach and how the net present value concept permits efficient separation of ownership and corporate management.
The main rationale for the net present value approach may be summarised as follows:
1 Managers are assumed to act in the best interests of the owners or shareholders,
even if agency costs – in the form of incentives or controls – have to be incurred.
They seek to increase shareholders’ wealth by maximising cash flows through time.
The market rate of exchange between current and future wealth is reflected in the
current rate of interest.
2 Managers should undertake all projects up to the point at which the marginal
return on the investment is equal to the rate of interest on equivalent financial
investments in the capital market. This is exactly the same as the net present value
rule: accept all investments offering positive net present values when discounted at
the equivalent market rate of interest. The result is an increase in the market value
of the firm and thus in the market value of the shareholders’ stake in the firm.
3 Management need not concern itself with shareholders’ particular time patterns of
consumption or risk preferences. In well-functioning capital markets, shareholders
can borrow or lend funds to achieve their personal requirements. Furthermore, by
carefully combining risky and safe investments, they can achieve the desired risk
characteristics for those consumption requirements. This argument is discussed
more fully in Appendix II.
MINI CASE
How NPV is used in debt relief to the poorest nations
The International Monetary Fund (IMF) and World Bank
have designed a framework to provide special assistance
for heavily indebted poor countries. It entails coordinated
action by the international financial community, including
banks and multinational companies, to reduce and
reschedule the debt burden to levels that countries can
service through exports and aid.
Net present value is central to the calculation of the sustainable debt level. The face value of debt stock is not a
good measure of a country’s debt burden if a significant
part of it is contracted on concessional terms, for example
with an interest rate below the prevailing market rate. The
net present value of debt is used to find the sum of all
future debt-service obligations (interest and principal) on
existing debt, discounted at the market interest rate.
Whenever the interest rate on the loan is lower than the
market rate, the resulting NPV of debt is smaller than its
face value, with the difference reflecting the grant element.
Question
Explain to a government official from one of the
world’s poorest countries why the NPV approach is an
appropriate method for calculating the sustainable
debt level.
Self-assessment activity 3.7
Why should managers seek to maximise net present value? Is business not about maximising profit?
(Answer in Appendix A at the back of the book)
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SUMMARY
We have examined the meaning of wealth and its fundamental importance in financial
management. Given that, for most capital projects, there is a time-lag between the initial investment outlay and the receipt of benefits, consideration must be given to both
the timing and size of the costs and benefits. Whenever there is an alternative opportunity to use funds committed to a project (e.g. to invest in the capital market or in
other capital projects), cash today is worth more than cash received tomorrow.
Key points
■
Money, like any other scarce resource, has a cost. We allow for the time-value of
money by discounting. The higher the interest cost for a future cash flow, the lower
its present value.
■
Discount tables take away much of the tedium of discounting – but computer
spreadsheets eliminate it altogether.
■
Standard discount factors are:
PVIF the present value interest factor,
PVIFA the present value interest factor for an annuity.
Conventional shorthand is:
Interest factor (rate of interest, number of years)
e.g. PVIFA110,32 reads ‘the present value interest factor for an annuity at 10 per cent
for three years’.
■
The term structure of interest rates shows how yields on bonds vary as the durations of loans increase.
■
The net present value (NPV) of a project is found by first discounting a project’s
future net cash flows at the minimum required rate of return for the project; and
then deducting the initial investment outlay from the total present values over the
project’s life.
■
Where the corporate goal is to maximise the wealth of its shareholders, the simple
decision rule is:
When the NPV is positive, accept the investment.
When the NPV is negative, reject the investment.
Further reading
The work of Hirshleifer (1958) and Tobin (1958) provides the background to the approach
adopted in Appendix II. Early writers on discounted cash flow include Fisher (1930) and Dean
(1951).
Useful websites
Discounted cash flow: www.investopedia.com
Annual percentage rate: www.moneyextra.com
www.investinginbonds.com
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78 Part I A framework for financial decisions
APPENDIX I
THE TERM STRUCTURE OF INTEREST RATES AND THE YIELD CURVE
Yield Curve
A graph depicting the relationship between interest rates
and length of time to maturity
■
We saw in Section 3.7 that the interest rate depends on a number of factors, one of
which is duration of the investment or loan. This is called the term structure of interest rates. It shows how the yields offered for loans of different maturities vary as the
term of the loan increases.
Relating this to bonds issued by the state, or government stock, the term structure
shows the rate of return expected, or yield, by today’s purchaser of stock who plans to
hold to maturity, or redemption, i.e. when the stock will be repaid, or redeemed, by
the government. It also shows how the yield varies for different lengths of time to
maturity. In graphical terms, it is shown by a relationship called the Yield Curve.
Normally, we find that yields to maturity increase as the term increases. In other
words, rates of interest on ‘longs’ are higher than on ‘shorts’, as Figure 3.3 shows.
Notice that the relevant yield is the Gross Redemption Yield, which includes both
interest payments and any capital gain or loss at redemption.
By tradition, short-dated stocks, with up to further five years to maturity are called
shorts, mediums have between five and 15 years before repayment and longs will be
paid beyond 15 years. Notice that longs include a number of irredeemables or perpetuities which quite literally will never be repaid but will attract interest forever. These
are also called undated stocks.
Explaining the shape of the Yield Curve
Three theories have been proposed to explain the shape of the Yield Curve – the
Expectations Theory, the Liquidity Preference Theory and the Market Segmentation
Theory. These are not mutually exclusive explanations – the influences incorporated in
each theory all tend to operate at any one time but with different degrees of pressure.
Sometimes, investors’ expectations (e.g. about future inflation) are predominant,
while, at other times, investors’ desire for liquidity may govern the shape of the curve.
Expectations theory
This theory asserts that investors’ expectations about future interest rates exert the
dominant influence. When the curve rises with years to maturity, this suggests that
Yield
(%)
‘Normal’ yield
curve
‘Inverted’ yield
curve
‘SHORTS’
Figure 3.3
The term structure of
interest rates
0
‘MEDIUMS’
5
10
‘LONGS’
15
Years to maturity
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Chapter 3 Present values and financial arithmetic
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people expect interest rates to rise in the future. This is reflected in the relative
demand for short-dated and long-dated securities – investors expect to be able to earn
higher rates in the future so they defer buying long-dated stocks, preferring to invest
in shorts. This pushes up the price on shorts, and thus lowers the yields on them, and
conversely, for longer-dated stock.
Liquidity preference theory
Most investors, being risk-averse, prefer to hold cash rather than securities – cash
is effectively free of risk (although banks do go bust!), while even the shortestdated government stocks carry a degree of risk. Here, by risk, we mean not the risk
of default, but the risk of not being able to find a willing buyer of the stock at an
acceptable price, i.e. liquidity risk. Consequently, investors need to be compensated for having to wait for the return of their money. Preference for liquidity now,
and risk avoidance, thus explains the shape of the yield curve. The longer the time
to maturity, the greater the risk of illiquidity and the higher the compensation
required.
Market segmentation theory
In developed markets, there is a wide range of investors with different needs and time
horizons who, therefore, focus on different segments of the yield curve. For example,
some financial institutions, such as banks, are anxious to protect their ability to allow
investors to withdraw their deposits freely – for them, shorts are very attractive as they
need liquidity. Conversely, pension funds have far longer-term liabilities and wish to
match the maturity stream of their assets to these quite predictable liabilities. For
them, longs are more suitable.
According to this view, the ‘short’ market is quite distinct from the ‘long’ market
and the two ends could behave quite differently under similar conditions. For
example, if the government is expected to be a net repayer of its debt in the future,
this suggests a shortage of longs. This is likely to increase the demand for those
stocks presently available and thus reduce their yields. This would explain the case
of the ‘inverted’ i.e. downward-sloping, yield curve, shown by the red line in Figure
3.3.
In Chapter 16, we will examine how firms can use the information contained in the
yield curve for their financial planning.
APPENDIX II
THE INVESTMENT–CONSUMPTION DECISION
■
Theoretical case for NPV
We have suggested that managers should base investment decisions on the net present value criterion: accept all projects that offer a positive net present value. We will
now justify this claim by presenting the theoretical case for the NPV rule.
There are three fundamental financial decisions facing individuals and shareholders:
1 Consumption decisions: how much of my available resources should I spend on immediate consumption?
2 Investment decisions: how much of the resources available should I forgo now in the
expectation of increased resources at some time in the future? How should such
decisions be made?
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80 Part I A framework for financial decisions
3 Financing decisions: how much cash should I borrow or lend to enable me to carry
out these investment and consumption decisions?
Clearly, these decisions are interrelated and should not be viewed in isolation.
Individuals are faced with the choice of how much of their wealth should be consumed immediately, and how much should be invested for consumption at a later
date. This applies equally to young children with their pocket money, undergraduates
with their grants, professionals with their capital, and shareholders with their investment portfolios. All these cases involve a trade-off between immediate and delayed
consumption.
We are primarily concerned with how managers should reach investment decisions.
Cash generated from business operations can be utilised in two ways: it can be distributed to the shareholders in the form of a dividend, or reinvested within the business. Periodically, the directors decide how much of the shareholders’ wealth to
distribute in the form of dividends and how much to withhold for investment purposes, such as building up stock levels or purchasing new equipment. The shareholders will only be willing to forgo a higher present level of consumption (in the form of
dividends) if they expect an even greater future level of consumption. This willingness
to give up consumption now in order to increase future consumption characterises
investment decisions.
■
Graphical example
Derek Platt is the sole proprietor of Platt Enterprises, a new business with just one
asset of £4 million in cash. He has a number of interesting investment ideas (all lasting
just a year), but before investing his capital within the business, he asks the following
key questions:
1 What return could I earn by investing my capital (or some part of it) in the capital
market?
2 How much should I invest within the business?
3 What is the net present value of the business?
Before addressing these issues and in order to present a conceptual framework for
the NPV rule, it is first necessary to make certain simplifying assumptions that allow
us to portray in two-dimensional form the essential features of the investment–
consumption decision model. The basic assumptions are as follows:
1 Investors are wealth-maximisers.
2 Only two periods are considered – the present period 1t0 2 and the next period 1t1 2.
This two-period model implies that investments involve an immediate cash outlay
in t0 in return for a cash benefit in the following period, t1.
3 All information for decision-making is known with certainty.
4 Investment projects are entirely independent of each other and are divisible.
These assumptions are clearly unrealistic in the setting within which investment
decisions are taken in practice. Nonetheless, they serve as a useful guide to the relevance and limitations of the net value approach.
Let us assume that Platt Enterprises has £4 million available for investment but
there are only two possible projects, each costing £2 million and having a one-year life.
Figure 3.4 illustrates the investment opportunities line for the two projects, showing
the cost of investing this year and the payoffs arising next year. Platt could invest
£4 million, in both projects, producing a £4 million payoff next year. But he would
probably prefer to invest only in project A, costing £2 million, but giving a payoff of
£3 million. Project B is unprofitable, offering only £1 million from £2 million investment. If there are no opportunities to invest surplus cash externally, say by putting it
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Chapter 3 Present values and financial arithmetic
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Period 1 (£m)
4
Investment
B
payoff
Investment opportunities
line
C
3
A
0
Figure 3.4
Investment opportunities for Platt Enterprises
2
B
A
Investment outlay
4
Period 0 (£m)
on deposit with a bank or investing in short-term securities, Platt would have to pay
a dividend to shareholders of the £2 million unused cash.
In this example, the choice was fairly straightforward. But if Platt had hundreds of
potential projects, it would be far harder to know where the cut-off point for investment
should be drawn. He requires a criterion for judging between cash today and cash
receivable next year. In effect, he requires a rate of exchange for the transfer of wealth
across time. Suppose he requires a minimum of £115 receivable next year to induce him
to give up £100 now, the rate of exchange would be £115t0 : £100t1 or £1.15 : £1. This represents a premium for delayed consumption of one year of
£115
1 0.15, or 15%
£100
This exchange rate between today’s money and tomorrow’s money varies with the
level of present consumption sacrificed. Platt may be willing to forgo the first £100 of
potential dividend in return for an additional 15 per cent next year, but to persuade
him to delay the consumption of a further £100 will probably require something in
excess of 15 per cent. This variable exchange rate for the transfer of wealth across time
at various levels of investment is termed the marginal rate of time preference, and differs from individual to individual.
The investment opportunities line is concave to the origin rather than a straight
line. This indicates the decreasing returns to scale of each subsequent investment
opportunity. As a wealth-maximiser, Platt will first select those investment projects
offering the greatest return and work down towards those offering the least return.
Point C represents the marginal project beyond which it ceases to be worthwhile to
invest – the marginal return from the next £1 in investment would not be sufficient to
compensate for the sacrifice involved in giving up a further £1 in dividends. For Platt,
C represents the point where the marginal return on investment equals his marginal
rate of time preference.
■
Borrowing and lending opportunities
So far, under our highly simplistic assumptions, our owner-manager, Platt, is given
only two decisions – consumption and investment. The more he invests, the less he can
consume now, and vice versa. This ignores the third choice open to him, namely the
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82 Part I A framework for financial decisions
6.0
Next year (£ million)
5.0
Owner’s consumption
requirement
4.2
4.0
3.0
M
2.4
Interest rate
2.0
Investment
opportunities
1.0
Figure 3.5
0
Investment and financing opportunities for
Platt Enterprises
1.0
1.5 2.0
Dividend
3.0
4.0
5.0
Today (£ million)
Invest
financing decision. Where capital markets exist, individuals and firms can buy and sell not
only real assets (i.e. fixed and current), but also financial assets. As we saw earlier in this
chapter, when perfect capital markets are introduced (i.e. no borrower can influence the
interest rate, all traders have equal and costless access to information, no transaction costs
or taxes), there will be a single market rate of interest for both borrowing and lending.
The existence of a capital market permits owners to transfer wealth across time in a
manner different from the investment–consumption pattern of the firm. This is shown
by the interest rate line in Figure 3.5, which represents the exchange rate between current and future cash flows under perfect capital market conditions. Its slope is 11 i2,
where i denotes the single period rate of interest.
In our example, the interest rate is found by relating present wealth to next year’s
wealth at any point on the graph. At the extremes, this is £6 million>£5 million 1.20.
The interest rate is therefore 20 per cent.
With the introduction of financing opportunities afforded by the capital market,
Platt can now identify the appropriate level of corporate investment. He should continue to invest until project M – where the interest rate line is tangential to the investment opportunities line. At this point, all investments offering a return at least as
high as the market rate of interest are accepted, since they all offer positive net present values. Reading off the graph in Figure 3.5, we find that investment as far as M
would mean a dividend of £3 million today and an investment of £1 million (i.e.
£4 million £3 million). It is not worth investing further as the projects offer negative
NPVs. It would be more beneficial for Platt to withdraw the £3 million from the business and to invest it in the capital market at 20 per cent p.a.
What then is the net present value of the £1 million investment programme envisaged
by Platt? Reading off the investment opportunities curve, we find that the capital outlay
will produce cash flows of £2.4 million next year. The NPV is therefore £1 million:
NPV £2.4 m
£1 m £2 m £1 m £1 m
1.2
The new value of the business becomes £5 million (starting capital of £4 million plus
NPV of investment programme).
We suggested earlier that the £3 million not invested by the firm would be paid
out as a dividend. An alternative would be for the firm to invest all or part of it on
behalf of the owners in the capital market until such time as investment opportunities
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Chapter 3 Present values and financial arithmetic
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offering positive NPVs arise. Suppose Platt is only looking for a dividend of £1.5 million. The extra £1.5 million can be invested in the capital market to earn £1.8 million
next year (i.e. £4.2 m £2.4 m, or £1.5 m 1.20). Platt’s cash flow next year will then
be the £2.4 million from capital investments plus the £1.8 million from financial
investments.
■
Separating ownership from management
Most firms are characterised by a large number of shareholders (owners), few of
whom are actively involved in the management of the firm. It is obviously impossible for managers to evaluate investment decisions on the basis of the personal
investment–consumption preferences of all the shareholders. Happily, the existence of
capital markets renders any such attempt unnecessary. Managers do not need to select
an investment programme whose cash flows exactly match shareholders’ preferred
time patterns of consumption. The task of the manager is to maximise present value
by accepting all investment proposals offering a return at least as good as the market
rate of interest.
This criterion maximises the current wealth of the shareholders, who can then
transform that wealth into whatever time pattern of consumption they require. They
can do this by lending or borrowing on the capital market until their marginal rate of
time preference equals the capital market rate of interest. This Separation Theorem, as it
is usually termed, leads to the following decision rules:
1 Corporate management should invest in projects offering positive net present values when discounted at the capital market rate.
2 Shareholders should borrow or lend on the capital market to produce the wealth distribution which best meets their personal time pattern of consumption requirements.
■
Capital market imperfections
Based on the assumptions laid down at the start of the chapter, managers should
undertake investments up to the point at which the marginal return on investment is
equal to the rate of return in the capital market. You will recall that two important
assumptions were the existence of perfect capital markets and the absence of risk.
When these assumptions are relaxed, the argument in favour of the net present value
rule becomes weaker. For one thing, there is no longer a unique rate of interest in the
capital market, but a range of interest rates varying with the status of the borrower, the
amount required and the perceived riskiness of the investment. A detailed analysis of
investment under risk is the subject of subsequent chapters, but at this stage we can
say that a project’s return should be compared with the rate of return on investments
in the capital market of equivalent risk – the greater the investment risk, the higher the
required rate of return.
A major concern involves the particular capital market imperfections where the
borrowing rate is substantially higher than the lending rate. In this case, the two-period
investment model will resemble Figure 3.6. The steeper line represents the interest
rate for the borrower and the flatter line represents the lending rate. The existence
of two different interest rates gives rise to two different points on the investment
opportunities line CD. Prospective borrowers, having to pay a higher rate of interest
for funds, would prefer the company to invest only BD this year (i.e. up to project Y).
However, prospective lenders will require the company to discount at the lower lending rate, leading to a much greater investment of AD, with investment X being the
marginal project.
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84 Part I A framework for financial decisions
Lending
rate
X
Period 1 (£)
C
Y
Borrowing rate
Figure 3.6
A
0
Investment decisions
in imperfect capital
markets
B D
Period 0 (£)
There is no simple solution to the investment–consumption decision when capital
market imperfections prevail. Fortunately, in the UK, USA, Japan and much of Western
Europe, capital markets are highly competitive and function fairly well, so that differences between lending and borrowing rates are minimised, but significant differentials
can be found in emerging capital markets such as that in Turkey.
APPENDIX III
PRESENT VALUE FORMULAE
■
Formula for the present value of a perpetuity
This formula derives from the present value formula:
PV X
X
X
p
1i
11 i2 2
11 i2 3
Let X>11 i2 a and 1>11 i2 b. We now have:
(i) PV a11 b b2 p 2
Multiplying both sides by b gives us:
(ii) PVb a1b b2 b3 p 2
Subtracting (ii) from (i) we have:
PV11 b2 a
Substituting for a and b,
PV¢1 1
X
≤
1i
1i
Multiplying both sides by 11 i2 and rearranging, we have:
PV X
i
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Chapter 3 Present values and financial arithmetic
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85
Formula for the present value of a growing perpetuity
In 1 above, we obtained:
PV 11 b2 a
Redefining b 11 g2>11 i2 and keeping a X>11 i2:
PV¢1 1g
1i
≤
X
1i
Multiplying both sides by 11 i2 and rearranging, we have:
PV ■
X
ig
The present value of annuities
The above perpetuities were special cases of the annuity formula. To find the present
value of an annuity, we can first use the perpetuity formula and deduct from it the
years outside the annuity period. For example, if an annuity of £100 is issued for 20
years at 10 per cent, we would find the present value of a perpetuity of £100 using the
formula:
PV X
100
£1,000
i
0.10
Next, find the present value of a perpetuity for the same amount, starting at year 20,
using the formula:
PV X
£100
£148.64
i11 i2 t
0.1011 0.102 20
The difference will be:
PV of annuity X
X
i
i11 i2 t
£1,000 £148.64 £851.36
The present value of an annuity of £100 for 20 years discounted at 10 per cent is
£851.36.
The formula may be simplified to:
1
1
PV of annuity X¢ ≤
i
i11 i2 t
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86 Part I A framework for financial decisions
QUESTIONS
Question with a coloured number have solution in Appendix B on page 692.
1 Explain the difference between accounting profit and cash flow.
2 Calculate the present value of a ten-year annuity of £100, assuming an interest rate of 20 per cent.
3 A firm is considering the purchase of a machine which will cost £20,000. It is estimated that annual savings of
£5,000 will result from the machine’s installation, that the life of the machine will be five years, and that its
residual value will be £1,000. Assuming the required rate of return to be 10 per cent, what action would you
recommend?
4 (Based on Appendix I to this chapter.) Ron Bratt decides to commence trading as a sportswear retailer, with
initial capital of £6,000 in cash. The capital market and investment opportunities available are shown below:
Year 1 (£000)
10
7
5
0
4
6
Now (£000)
8
You are required to calculate:
(a)
(b)
(c)
(d)
(e)
(f)
How much the firm should invest in real assets.
The market rate of interest for the business.
The average rate of return on investment.
The net present value of the investment.
The value of the firm after this level of investment.
Next year’s dividend if Bratt only requires a current dividend of £3,000.
5 The gross yield to redemption on government stocks (gilts) are as follows:
Treasury 8.5% 2000
Exchequer 10.5% 2005
Treasury 8% 2015
7.00%
6.70%
6.53%
(a) Examine the shape of the yield curve for gilts, based upon the information above, which you should use
to construct the curve.
(b) Explain the meaning of the term ‘gilts’ and the relevance of yield curves to the private investor.
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Chapter 3 Present values and financial arithmetic
6 Calculate the net present value of projects A and B, assuming discount rates of 0 per cent, 10 per cent and 20
per cent.
Initial outlay
Cash receipts:
Year 1
Year 2
Year 3
A (£)
B (£)
1,200
1,200
1,000
500
100
100
600
1,100
Which is the superior project at each level of discount rate? Why do they not all produce the same answer?
7 The directors of Yorkshire Autopoints are considering the acquisition of an automatic car-washing installation. The initial cost and setting-up expenses will amount to about £140,000. Its estimated life is about seven
years, and estimated annual accounting profit is as follows:
Year
1
2
3
4
5
6
7
Operations cash flow (£)
Depreciation (£)
30,000
20,000
50,000
20,000
60,000
20,000
60,000
20,000
30,000
20,000
20,000
20,000
20,000
20,000
Accounting profit (£)
10,000
30,000
40,000
40,000
10,000
–
–
At the end of its seven-year life, the installation will yield only a few pounds in scrap value. The company
classifies its projects as follows:
Required rate of return
Low risk
Average risk
High risk
20 per cent
30 per cent
40 per cent
Car-washing projects are estimated to be of average risk.
(a) Should the car-wash be installed?
(b) List some of the popular errors made in assessing capital projects.
Practical assignment
List three decisions in a business with which you are familiar where cash flows arise over a lengthy time period
and where discounted cash flow (DCF) may be beneficial. To what extent is DCF applied (formally or intuitively)?
What are the dangers of ignoring the time-value of money in these particular cases?
87
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88 Part I A framework for financial decisions
4
Valuation of assets, shares and companies
Must do better …
Provision of training courses and learning materials
for students preparing for professional accounting
exams is now big business, with a number of listed
companies involved. In June 1998, the first quoted
operator, Nord Anglia plc, acquired EW Fact, a leading
accountancy training firm, for £19 million. After the
acquisition, Nord Anglia was dismayed to find that
restructuring costs were much higher than expected.
In May 1999, Nord Anglia announced a profits warning and also that it was considering legal action against
EW Fact for ‘materially overstating’ profits for the year
before acquisition. Nord Anglia’s chairman alleged that
pre-tax profits in 1997, posted at £1.4 million, should
have been just £80,000. This knowledge would presumably have affected the sum that Nord Anglia would
have paid to acquire EW Fact. Shares in Nord Anglia fell
from 230p to 187p on the announcement.
The Daily Telegraph quipped: ‘The sort of mistake
any student can make, of course. But not what should
be expected from auditors – if properly trained’.
Learning objectives
The ultimate effectiveness of financial management is judged by its contribution to the value of the
enterprise. This chapter aims:
■
To provide an understanding of the main ways of valuing companies and shares, and of the limitations of these methods.
■
To stress that valuation is an imprecise art, requiring a blend of theoretical analysis and practical
skills.
■
To introduce the dividend valuation model, an important underpinning of the analysis of dividend
policy in Chapter 17.
A sound grasp of the principles of valuation is essential for many other areas of financial management.
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Chapter 4 Valuation of assets, shares and companies
4.1
89
INTRODUCTION
The concept of value is at the heart of financial management, yet the introductory case
demonstrates that valuation of companies is by no means an exact science. Inability to
make precisely accurate valuations complicates the task of financial managers.
The financial manager controls capital flows into, within and out of the enterprise
attempting to achieve maximum value for shareholders. The test of his/her effectiveness is the extent to which these operations enhance shareholder wealth. He/she
needs a thorough understanding of the determinants of value to anticipate the consequences of alternative financial decisions. If there is an active and efficient market in
the company’s shares, it should provide a reliable indication of value. However, managers may feel that the market is unreliable, and may wish to undertake their own valuation exercises. Indeed, some managers behave as though they doubt the Efficient
Markets Hypothesis (EMH), outlined in Chapter 2.
In addition, there are specific situations where financial managers must undertake
valuations, for example, when valuing a proposed acquisition, or assessing the value
of their own company when faced with a takeover bid. Directors of unquoted companies may also need to apply valuation principles if they intend to invite a takeover
approach from a larger firm or if they decide to obtain a market quotation.
Valuation skills thus have an important strategic dimension. In order to advise on
the desirability of alternative financial strategies, the financial manager needs to assess
the value to the firm of pursuing each option. This chapter examines the major difficulties in valuation and explains the main methods available.
4.2
THE VALUATION PROBLEM
price-earnings multiples
The price-earnings multiple, or
ratio (PER), is the ratio of earnings (i.e. profit after tax) per
share (EPS) to market share
price
Anyone who has ever attempted to buy or sell a second-hand car or house will appreciate that value, like beauty, is in the eye of the beholder. Value is whatever the highest
bidder is prepared to pay. With a well-established market in the asset concerned, and if
the asset is fairly homogeneous, valuation is relatively simple. So long as the market is
reasonably efficient, the market price can be trusted as a fair assessment of value.
Problems arise in valuing unique assets, or assets that have no recognisable market,
such as the shares of most unquoted companies. Even with a ready market, valuation
may be complicated by a change of use or ownership. For example, the value of an
incompetently-managed company may be less than the same enterprise after a shakeup by replacement managers. But by how much would value increase? Valuing the
firm under new management would require access to key financial data not readily
available to outsiders. Similarly, a conglomerate that has grown haphazardly may be
worth more when broken up and sold to the highest bidders. But who are the prospective bidders, and how much might they offer? Undoubtedly, valuation in practice
involves considerable informed guesswork. (Inside information often helps as well!)
Regarding the introductory case, we do not know how the valuation was arrived at,
but we can see that even the ‘experts’ can get it wrong. This illustrates an important
lesson – the only certain thing about a valuation is that it will be ‘wrong’! However,
this is no excuse for hand-wringing. A key question is whether the valuations were
reasonable in the light of the information then available.
The three basic valuation methods are net asset value, price–earnings multiples
and discounted cash flow. None of these is foolproof, and they often give different
answers. Moreover, different approaches may be required when valuing whole companies from those appropriate to valuing part shares of companies. In addition, the
value of a whole company (i.e. the value of its entire stock of assets) may differ from
the value of the shareholders’ stake. This applies when the firm is partly financed by
debt capital.
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90 Part I A framework for financial decisions
■
Enterprise value vs. equity value: Innogy plc
To persuade the present owners to sell, a bidder has to offer an acceptable price for
their equity and expect to take on responsibility for the company’s debt. Consider the
purchase in 2002, by RWE Ag, the German multi-utility group of the British electricity supplier, Innogy, itself a spin-off from the privatised company, International Power.
RWE’s logic was to complement its previous acquisition of Thames Water in 2000 in
order to gain access to 10 million customer accounts to which it could offer gas, electricity and water. The overall deal was valued at around £5 billion, comprising some
£3 billion of equity and £2 billion of debt.
Innogy’s stock of assets was financed partly by equity and partly by debt. To obtain
ownership of all the assets, i.e. the whole company, RWE was obliged to offer £3 billion to the shareholders to induce them to sell, and either pay off the debt or assume
responsibility for it. Although RWE chose the latter route, either course of action made
the cost of the acquisition £5 billion.
Obviously, to make the acquisition worthwhile to RWE its own (undisclosed) valuation would presumably have exceeded £5 billion. We thus encounter several different concepts of value:
Value of company to the buyer:
Cost to acquire company:
Value of equity stake required to clinch sale:
Value of equity stake perceived by owners:
net asset value approach
Calculation of the equity value
in a firm by netting the liabilities against the assets
probably more than £5 billion
£5 billion
£3 billion
possibly below £3 billion
The distinction between company value and the value of the owners’ stake is clarified by considering the first method of valuation, the net asset value approach, which
is based on scrutiny of company accounts.
Self-assessment activity 4.1
Using the Innogy example, distinguish between the value of a whole company and the
value of the equity stake. When would these two measures coincide?
(Answer in Appendix A at the back of the book)
4.3
VALUATION USING PUBLISHED ACCOUNTS
Using the asset value stated in the accounts has obvious appeal for those impressed by
the apparent objectivity of published accounting data. The Balance Sheet shows the
recorded value for the total of fixed assets (sometimes, but not invariably, including intangible assets) and current assets, namely stocks and work-in-progress, debtors, and other
holdings of liquid assets such as cash and marketable securities. After deducting the debts
of the company, both long- and short-term, from the total asset value (i.e. the value of the
whole company) the residual figure is the net asset value (NAV), i.e. the value of net
assets or the book value of the owners’ stake in the company or, simply, ‘owners’ equity’.
The Balance Sheet for DS Smith plc, the paper and packaging group, is shown in Table 4.1.
The Balance Sheet in its modern vertical form pinpoints the NAV, the net assets figure, £562.0
million, which, by definition, must coincide with shareholders’ funds, i.e. the value of the
shareholders’ stake net of all liabilities (and, in this case, net of a small minority item, i.e.
residual ownership in an acquired firm). (The book value of the whole company, i.e. its total
assets, is fixed assets plus current assets (£785.1 m £578.0 m) £1,363.1 m.) However,
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Chapter 4 Valuation of assets, shares and companies
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Table 4.1 Balance Sheet for DS Smith plc as at 30 April 2004
Assets employed
Fixed assets (net)
Current assets:
Stocks
Debtors
Cash and investments
Creditors falling due within one year
Net current assets
Total assets less current liabilities
Creditors falling due after one year (inc. provisions)
Minority interests
Net assets (NAV)
Financed by:
Called-up share capital
Share premium account
Profit and loss account
Revaluation reserve
Shareholders’ funds (NAV)
£m
£m
785.1
154.9
361.5
61.6
(401.2)
176.8
961.9
(394.1)
(5.8)
562.0
38.7
254.6
260.2
8.5
562.0
Source: DS Smith plc, Annual Report 2004 (www.dssmith.uk.com)
the NAV is a very unreliable indicator of value in most circumstances. Most crucially, it
derives from a valuation of the separate assets of the enterprise, although the accountant will
assert that the valuation has been made on a ‘going concern basis’, i.e. as if the bundle of
assets will continue to operate in their current use. Such a valuation often, but not invariably,
understates the earning power of the assets, particularly for profitable companies.
In July 2004, the market value of DS Smith’s equity was £596 million (share price of 154p
times number of 10p shares, i.e. 387 million). Hence, the net assets were apparently worth
rather less than the firm as a going concern with its existing and expected strategies, management and skills, all of which determine its ability to generate profits and cash flows. If
the profit potential of a company is suspect, however, then break-up value assumes greater
importance. The value of the assets in their best alternative use (e.g. selling them off) might
then exceed the market value of the business, providing a signal to the owners to disband
the enterprise and shift the resources into those alternative uses. Sometimes, then we may
be able to adjust the NAV to take into account more up-to-date, or more relevant information, thus obtaining the Adjusted NAV.
Self-assessment activity 4.2
For DS Smith plc, identify:
(i) the value of the whole firm, i.e. enterprise value
(ii) the value of its total liabilities
(iii) the value of the owners’ equity.
(Answer in Appendix A at the back of the book)
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92 Part I A framework for financial decisions
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Problems with the NAV
The NAV, even as a measure of break-up value, may be defective for several reasons.
1 Fixed asset values are based on historical cost
replacement cost
The cost of replacing the existing assets of a firm with assets
of similar vintage capable of
performing similar functions
Book values of fixed assets, e.g. £785.1 million for DS Smith, are expressed net of
depreciation, the result of writing down asset values over their assumed useful lives.
Depreciating an asset, however, is not an attempt to arrive at a market-oriented assessment of value but an attempt to spread out the historical cost of an asset over its
expected lifetime so as to reflect the annual cost of using it. It would be an amazing
coincidence if the historical cost less accumulated depreciation were an accurate measure of the value of an asset to the owners, especially at times of generally rising prices.
Some companies try to overcome this problem by periodic valuations of assets, especially freehold property. However, few companies do this annually, and even when
they do, the resulting estimate is valid only at the stated dates. Whichever way we
look at it, fixed asset values are always out of date!
A more sophisticated approach (but thus far stoutly resisted by the accounting profession) is to adopt current cost accounting (CCA). Under CCA, assets are valued at
their replacement cost, i.e. what it would cost the firm now to obtain assets of similar
vintage. For example, if a machine cost £1 million five years ago, and asset prices
have inflated at 10 per cent p.a., the cost of a new asset would be about £1.6 million,
i.e. £1 m (1.10)5. The historical cost less five years’ depreciation on a straight-line
basis, and assuming a ten-year life, would be £0.5 million. However, the cost of
acquiring an asset of similar vintage would be around £0.8 million.
There are obvious problems in applying CCA. For example, estimating current cost
requires knowledge of the rate of inflation of identical assets, and of the impact of
changing technology on replacement values. Nevertheless, the replacement cost measure is often far closer to a market value than historical cost less depreciation. Ideally,
companies should revalue assets annually, but the time and costs involved are generally considered prohibitive.
Asset values may also fall. Directors are legally required to state in the annual
report if the market value of assets is materially different from book value. It is better
to ‘bite the bullet’ and actually reduce the value of poorly-performing assets in the
accounts. This was done by BT in September 2001 when it announced a charge of £500
million in its first-half results to reflect the reduced value of its disastrous 9 per cent
holding in AT&T Canada and its 20 per cent holding in Impsat of Argentina.
The highest write-off to date was the $50 billion write-down in 2003 by Worldcom
(later renamed MCI) of assets acquired during an acquisition spree, following which
several executives saw the inside of jails after convictions for false accounting. Write-offs
are, in effect, an admission that profits have been overstated in the past, (i.e.) depreciation has been too low. Firms tend to increase write-offs during difficult trading times on
the principle of unloading all the bad news in one go. In the USA, Goldman Sachs, the
merchant bank, reckoned that write-offs in 2002 rose to 140% of corporate earnings.
Under the new International Reporting Standards (IFRSs), UK firms will no longer have to
depreciate goodwill (the difference between the price paid for an acquisition and the book
value of the assets acquired), but to carry out an annual ‘impairment review’, which is already
the US practice. The results of the switch to IFRSs can be remarkable. In January 2005,
Vodafone, which has grown rapidly by acquisition, revealed that its loss of £1.88 billion for
the six months ending September 2004 would have been shown as a profit of £4.5 billion
under IFRSs.
2 Stock values are often unreliable
Under Generally Accepted Accounting Practice (GAAP), stocks are valued at the lower
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Chapter 4 Valuation of assets, shares and companies
93
of cost or net realisable value. Such a conservative figure may hide appreciation in the
value of stocks, e.g. when raw material and fuel prices are rising. Conversely, in some
activities, fashions and tastes change rapidly, and although the recorded stock value
might have been reasonably accurate at the Balance Sheet date, it may look inflated some
time later.
3 The debtors figure may be suspect
Similar comments may apply to the recorded figure for debtors. Not all debtors can be
easily converted into cash, since debtors may include an element of dubious or bad
debts, although some degree of provision is normally made for these.
The debtor collection period, supplemented by an ageing profile of outstanding
debts, should provide clues to the reliability of the debtors position.
4 A further problem: valuation of intangible assets
Even if these problems can be overcome, the resulting asset valuation is often less than
the market value of the firm. ‘People businesses’ typically have few fixed assets and
low stock levels. Based on the accounts, several leading quoted advertising agencies
and consultancies have tiny or even negative NAVs.
However, they often have substantial market values because the people they employ
are ‘assets’ whose interactions confer earning power – the quality that ultimately determines value. This may be seen most clearly in the case of professional football clubs,
few of which place a value for players on their Balance Sheets. Manchester United led
the way in this respect when it valued its players prior to flotation on the market in
1991. There are 17 quoted football companies in the Financial Times listings, fifteen
English and two Scottish. Is your club shown in Table 4.2?
Vanishing stock values (USA: stock=inventory)
In March 2000, shares in New Economy powerhouse Cisco Systems Inc. peaked at $80. Cisco,
whose remarkable growth was founded on making gear to power the internet, was now planning
to re-focus on selling equipment to new-world telecoms companies planning to supplant
‘dinosaurs’ like AT&T.
Yet its customers were beginning to complain about long lead times for products. So Cisco
entered into long-term supply contracts with suppliers and manufacturers to ensure the availability of customised components. But, already, the US economy was slowing down, reducing
demand for Cisco’s products. In April 2001, Cisco announced that sales for the current quarter
were set to drop by 30 per cent, driving the share price down to a 52-week low of $13.63.
In May 2001, Cisco announced a third quarter loss of $2.7 billion, a loss struck after a writedown of excess stock by $2.2 billion, 70 per cent of this involving telecom gear and parts. The
amount and the timing of the write-down surprised many. Cisco’s inventory, valued at $4.1 billion for the quarter ending April 2001, was 65 per cent higher than the previous quarter’s $2.5
billion, itself up from $1.3 billion a year earlier. Over the whole year, Cisco was clearly adding
inventory that it knew it could not sell, given weak demand and rapid technological change. This
raised the issue of why it had not disclosed any similar write-downs in previous quarters. The
Cisco case clearly illustrates the folly of rapid stock-building of high-tech products based on suspect demand forecasts.
Valuation of brands
However, some other companies have attempted to close the gap between economic
value and NAV by valuing certain intangible assets under their control, such as brand
names.
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94 Part I A framework for financial decisions
Table 4.2
Football clubs quoted on
the London Stock
Exchange
■
Aston Villa
■
Heart of Midlothian
■
Shelfield United
■
Birmingham City
■
Leeds United
■
Southampton Leisure Holdings
■
Burndene
Investments (Bolton)
■
■
■
Celtic
■
Manchester United
Millwall
Newcastle United
■
Sunderland
Tottenham Hotspur
Watford Leisure
■
Charlton Athletic
■
Preston North End
■
West Bromwich Albion
■
■
The brand valuation issue came to the fore in 1988 when the Swiss confectionery and
food giant Nestlé offered to buy Rowntree, the UK chocolate manufacturer, for more than
double its then market value. This generated considerable discussion about whether and
why the market had undervalued Rowntree and perhaps other companies that had
invested heavily in brands, either via internal product development or by acquisition.
Later that year, Grand Metropolitan Hotels (now Diageo) decided to capitalise acquired
brands in their accounts, and were followed by several other owners of ‘household name’
brands, such as Rank-Hovis-McDougall, which capitalised ‘home-grown’ brands.
Decisions to enter the value of brands in Balance Sheets were partly a consequence of
the prevailing official accounting guidelines, relating to the treatment of assets acquired
at prices above book value, often termed ‘goodwill’. These guidelines enabled firms to
write off goodwill directly to reserves, thus reducing capital, rather than carrying it as
an asset to be depreciated against income in the Profit and Loss Account, as in the USA
and most European economies. UK regulations allowed companies to report higher
earnings per share, but with reduced shareholder funds, thus raising the reported return
on capital, especially for merger-active companies. Such write-offs were stopped by a
new accounting standard, FRS10, which also prevented capitalisation of ‘home-grown’
brands. (FRS 10 obliged UK firms to follow US practice by depreciating goodwill. Under
IFRSs, to be adopted by listed UK firms from 2005, acquired goodwill need only be
depreciated if there is judged to be a ‘substantial impairment’ in the value of the asset.)
Brand valuation raises the value of the intangible assets in the Balance Sheet and thus
the NAV. Some chairpeople have presented the policy as an effort to make the market
more aware of the ‘true value’ of the company. Under strong-form capital market efficiency, the effect on share price would be negligible, since the market would already be aware
of the economic value of brands. However, under weaker forms of market efficiency, if
placing a Balance Sheet value on brands provides genuinely new information, it may
become an important vehicle for improving the stock market’s ability to set ‘fair’ prices.
■
Methods of brand valuation
Many methods are available for establishing the value of a brand, all of which purport
to assess the value to the firm of being able to exploit the profit potential of the brand.
1 Cost-based methods
At its simplest, the value of a brand is the historical cost incurred in creating the intangible asset. However, there is no obvious correlation between expenditure on the brand
and its economic value, which derives from its future economic benefits. For example,
do failed brands on which much money has been spent have high values? Replacement
cost could be used, but it is difficult to estimate the costs of re-creating an asset without
measuring its value initially. Alternatively, one may look at the cost of maintaining the
value of the brand, including the cost of advertising and quality control. However, it is
difficult to differentiate between expenditure incurred in maintaining the value of an
asset and investment expenditure which enhances its value.
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2 Methods based on market observation
Here, the value of the brand is determined by looking at the prices obtained in transactions involving comparable assets, for example, in mergers and acquisitions. This
may be based on a direct price comparison, or by separating the market value of the
company from its net tangible assets or by looking at the P:E multiple at which the deal
took place, compared to similar unbranded businesses. Although the logic is more
acceptable, the approach suffers from the infrequency of transactions involving similar
brands, given that individual brands are supposedly unique.
3 Methods based on economic valuation
In general, the value of any asset is its capitalised net cash flows. If these can be readily identified, this approach is viable, but it requires separation of the cash flows associated with the brand from other company cash inflows. The ‘brand contribution
method’ looks at the earnings contributed by the brand over and above those generated by the underlying or ‘basic’ business. The identification, separation and quantification of these earnings can be done by looking at the financial ratios (e.g. profit margin,
ROI), of comparable non-branded goods and attributing any differential enjoyed by the
brand itself as stemming from the value of the brand, i.e. the incremental value over a
standard or ‘generic’ product.
For example, if a brand of chocolates enjoys a price premium of £1 per box over a
comparable generic product, and the producer sells ten million boxes per year, the
value of the brand is imputed as (£1 10 m) £10 m p.a., which can then be discounted accordingly to derive its capital value. Alternatively, looking at comparative
ROIs as between the branded manufacturer and the generic, we may find a 5 per cent
differential. If capital employed by the former is £100 million, this implies a profit differential of £5 million, which is then capitalised accordingly.
Such approaches beg many questions about the comparability of the manufacturers
of branded and non-branded goods, the life span assumed, and the appropriate discount rate. Adjustments should also be made for brand maintenance costs, such as
advertising, that result in cash outflows.
4 Brand strength methods
Other, more intuitive, methods have been devised which purport to capture the
‘strength’ of the brand. This involves assessing factors like market leadership, longevity, consumer esteem, recall and recognition, and then applying a subjectively determined multiplier to brand earnings in order to derive a value. Although appealing, the
subjectivity of these approaches divorces them from commercial reality.
No broad measure of agreement has yet been reached about the best method to use
in brand valuation, or whether the whole exercise is meaningful. Indeed, a report commissioned by the ICAEW (1989), which rejected brand valuation for Balance Sheet
purposes, was said to have been welcomed by its sponsors. The report claimed that
brand valuation ‘is potentially corrosive to the whole basis of financial reporting’,
arguing that Balance Sheets do not purport to be statements of value!
Capturing the indefinable value of a brand
FT
Its contribution to the company’s
European companies find them- soft drink maker’s brand. So said
selves having to value their Interbrand, the consulting firm, last worth is far from unusual. Brands,
year when it ranked the Coca-Cola together with other intangibles such
intangibles
Two-thirds of Coca-Cola’s market name as the world’s most expensive
value is attributable to one asset: the at $67bn.
Continued
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96 Part I A framework for financial decisions
as customer relationships and technology, account for an ever-growing
proportion of corporate value: 48 per
cent, according to PwC research on
the American M&A market in 2003.
European Union companies have
not had cause to put detailed numbers on what makes them what they
are. But that is now changing,
because international accounting
standards force acquirers to spell out,
item by item, the value of the businesses they are buying.
That has created a new market for
expertise from the US, where intangibles have been shown separately
on balance sheets for several years.
Two specialist groups are in expansion mode in Europe – American
Appraisal and Standard & Poor’s
Corporate Value Consulting – while
the big four accounting firms are
plugging their services more heavily.
But as Sarpel Ustunel, senior
manager at American Appraisal in
London explains, there is no simple
way to put a price on something ‘that
is difficult to put your arms around’.
Mr Ustunel, one of 200 staff in
Europe, says there are several options
with brands.
■
One method is to calculate what
proportion of a company’s future
earnings can be attributed to its
property, machinery and other assets.
The rest should represent the value
of the brand. But this assumes there
are already neat values for the other
intangibles.
Another way is to estimate how
much it would cost to buy the brand if
the company did not own it already.
Alternatively, and if possible, valuers look for the equivalent of two
tins of soup made to exactly the same
specifications, and sold on the same
supermarket shelf – but one under a
specialist mark and one under the
supermarket’s own label. ‘Whatever
the difference in price is attributable
to the brand,’ says Mr Ustunel.
Valuing intellectual property, too,
is vexatious. If a patent for a similar
technology has been sold before that
price can be a starting point, he says,
but such data is difficult to come by.
The solution is to talk to as many
people as possible about the technology’s importance. ‘Engineers,’ he cautions, ‘can be overenthusiastic in
explaining what their technology is
about. Once you talk to the acquirer
you may find they were unaware it
existed.’
Valuing intangibles takes accounting, and the auditors who have to
check financial statements, into a
murky area. Given the need to make
assumptions and estimates, Richard
Winter, partner in valuation and
strategy at PwC, concedes: ‘There is
a degree of rattle room.’
People may think there is a definitive answer, but inevitably there is
scope for judgment.’
Critics say the whole exercise is
misleading because it implies a precision that is not really there.
‘The huge danger with going into
inordinate detail is that readers of
accounts cannot understand how the
numbers arise,’ says Ian Robertson,
president of the Institute of Chartered
Accountants of Scotland.
Mr Ustunel accepts there are no
black and white answers, but says
putting more numbers on the balance sheet is a useful step forward.
‘Would you rather I tell you there
are three cupboards, a table and a
few chairs in this room,’ he asks, ‘or
would you prefer just to know there
is some furniture?’
Source: Barney Jopson, Financial Times,
9 February 2005.
The role of the NAV
Generally speaking, the NAV, even when based on reliable accounting data, only really
offers a guide to the lower limit of the value of owners’ equity, but even so, some form
of adjustment is often required. Assets are often revalued as a takeover defence tactic.
The motive is to raise the market value of the firm and thus make the bid more expensive and difficult to finance. However, the impact on share price will be minimal
unless the revaluation provides new information, which largely depends on the perceived quality and objectivity of the ‘expert valuation’.
We conclude that while the NAV may provide a useful reference point, it is unlikely
to be a reliable guide to valuation. This is largely because it neglects the capacity of the
assets to generate earnings. We now consider the commonest of the earning-based
methods of valuation, the use of price-to-earnings multiples.
4.4
VALUING THE EARNINGS STREAM: P:E RATIOS
It is well known that accounting-based measures of earnings are suspect for several reasons, including the arbitrariness of the depreciation provisions (usually based on the
historic cost of the assets) and the propensity of firms to designate unusually high items
price-to-earning multiplier/ of cost or revenue as ‘exceptional’ (i.e. unlikely to be repeated in magnitude in future
P:E ratio
years). Yet we find that one of the commonest methods of valuation in practice is based
Another way of expressing
on accounting profit. This method uses the price-to-earnings multiple or P:E ratio.
the PER
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97
The meaning of the P:E ratio
As we saw in Chapter 2, the P:E ratio is simply the market price of a share divided by
the last reported earnings per share (EPS). P:E ratios are cited daily in the financial
press and vary with market prices. A P:E ratio measures the price that the market
attaches to each £1 of company earnings, and thus superficially (at least) is a sort of
payback period. For example, for its financial year 2004–5, Severn Trent Water plc
reported EPS of 56p. Its share price in late August 2005 was 958p producing a P:E
ratio of 18.7. Allowing for daily variations, the market seemed to indicate that it was
prepared to wait 18–19 years to recover the share price, on the basis of the latest earnings. So would a higher P:E ratio signify a willingness to wait longer? Not necessarily, because companies that sell at relatively high P:E ratios do so because the market
values their perceived ability to grow their earnings from the present level. Contrary
to some popular belief, a high P:E ratio does not signify that a company has done
well, but that it is expected to do better in the future. (Not that they always do – witness the very high P:E ratios among ‘dotcom’ companies in 1999–2000.)
The P:E ratio varies directly with share price, but it also derives from the share price,
i.e. from market valuation, so how does this help with valuation? Investment analysts
typically have in mind what an ‘appropriate’ P:E ratio should be for particular share
categories and individual companies, and look for disparities between sectors and
companies. If, for example, BP is selling at a P:E ratio of say 17 with EPS of 30p, and
Shell has EPS of 25p with a P:E ratio of 14, then their share values may look out of line.
Assuming Shell’s shares are correctly valued at (14 25p) 350p, then BP’s shares,
priced at (17 30p) 510p, might appear overvalued.
Of course, there is a circularity here – this conclusion relies on the assumption that
Shell rather than BP is correctly valued. Moreover, despite the apparent similarity of
these two oil majors, there may be very good reasons why they should be valued differently. BP operates further ‘upstream’ (away from the final consumer) than Shell,
and hence the sustained upward pressure on oil prices during 2005 would work to its
advantage. Meanwhile, Shell was experiencing major problems concerning the accuracy of its accounting and its corporate governance, both depressing share price.
Using P:E ratios to detect under- or over-valuation implies that markets are slow or
inefficient processors of information, but there are reliable rough benchmarks that
can be utilised. The industry benchmark is established by one or more transactions,
against which other deals in the same industry can be judged, and exceptions identified. In some industries, analysts use benchmarks other than the earnings figure
implicit in the P:E ratio. Some examples are multiples of billings in advertising, sale
price per room in hotels, price per subscriber in mail order businesses, price per bed
in nursing homes, and the more grisly ‘stiff ratio’ (value per funeral) in the undertaking business. At the height of the ‘dotcom boom’, some analysts attempted to explain
the stratospheric valuations of internet companies in terms of number of ‘hits’ or visits to the site in question. More analysts are now utilising multiples based on cash flow.
This development hints at the major problem with using P:E ratios – it relies on
accounting profits rather than the expected cash flows which confer value on any item.
We now consider cash-flow-oriented approaches to valuation.
Self-assessment activity 4.3
XYZ plc, which is unquoted, earns profit before tax of £80 million. It has issued 100 million shares. The rate of Corporation Tax is 30 per cent.
A similar listed firm sells at a P:E ratio of 15:1. What value would you place on XYZ’s shares?
(Answer in Appendix A at the back of the book)
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4.5
EBITDA – A HALFWAY HOUSE
Cash flows and profits differ due to application of accruals accounting principles, but
value depends upon cash generating ability rather than ‘profitability’. An intermediate
concept currently in vogue is that of EBITDA, an unattractive acronym standing for
Earnings Before Interest, Taxes, Depreciation and Amortisation. EBITDA is equivalent to operating profit with depreciation and amortisation (the writing-down of intangible assets) added back. As such, it is a measure of the basic operating cash flow before
deducting tax, but ignoring working capital movements.
Many companies use EBITDA as a measure of performance, especially when
related to capital employed. For example, E.On Ag www.eon.com the German utility and chemicals group, defines EBITDA as ‘earnings before interest, taxes, depreciation and goodwill amortisation’, and relates it to capital employed to calculate a
key indicator for monitoring the performance of business units. This is essentially
a cash-based measure of return on capital employed, which is not influenced by the
capital structure. In other words, being expressed before interest and tax, it is independent of financing policy, and thus the ‘share-out’ of the operating profit as
between interest payments, taxation and profits for shareholders. (It should be
noted that E.On adjusts the EBITDA to allow for exceptional items such as gains
and losses on disposals.)
However, EBITDA is essentially a performance measure. It can only be used in valuation if we look at the way in which the market values other companies’ EBITDAs. As
with P:E ratios, comparison with other companies is needed as a reference point. For
example, in late 2000, when Coca-Cola was evaluating Quaker as an acquisition candidate, observers noted that Coke was prepared to pay some 16 times Quaker’s EBITDA,
which appeared expensive, being well above recent deals in the US food sector.
Attempting to explain this, the Financial Times suggested that if the Quaker food division were valued at the then prevailing industry average of ten times EBITDA, then the
bid price implied an EBITDA multiple of 25 times for the real jewel in Quaker’s crown,
the fast-growing Gatorade sports drink.
In July 2001, the US oil firm Amerada Hess acquired Triton Energy in order to acquire
its upstream capability and exploration skills. The price paid per share was $45 cash, a premium of 50 per cent to Triton’s previous share price. The comment was made that it was
paying ‘top dollar’. Including some $500 million of debt, Amerada was laying out nine
times 2001 EBITDA, in line with similar deals involving acquisition of proven reserves but
ahead of valuations for oil companies oriented more towards downstream activities.
Like a P:E multiple, an EBITDA multiple used in valuation stems from the value
which the market attaches to other companies’ EBITDAs, which invites the question
of how it values those other companies, i.e. the EBITDA multiple is led by the valuation. Moreover, even when used crudely as a rough-and-ready comparison of value,
one should appreciate that it is still based on accounting earnings. Although gross of
depreciation and special items, it is still subject to different accounting practices
between firms at the operating level, e.g. stock valuation.
Continuing to focus on income-generating methods, we now examine the genuine
article, Discounted Cash Flow.
4.6
VALUING CASH FLOWS
The value of any asset depends upon the stream of benefits that the owner expects to
enjoy from his or her ownership. Sometimes these benefits are intangible, as in the case
of Van Gogh’s Sunflowers, which simply gives aesthetic pleasure to people looking at it.
In the case of financial assets, the benefits are less subjective. Ownership of ordinary
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shares, for example, entitles the holder to receive a stream of future cash flows in the
form of dividends plus a lump sum when the shares are sold on to the next purchaser,
or if held until the demise of the company, a liquidating dividend when it is finally
wound up. In the case of an all-equity financed company, the earnings over time should
be compared on an equivalent basis by discounting them at the minimum rate of return
required by shareholders or the cost of equity capital (henceforth denoted as ke).
■
Valuing a newly created company: Navenby plc
Navenby plc is to be formed by public issue of one million £1 shares. It proposes to purchase and let out residential property in a prime location. It has been agreed that, after
five years, the company will be liquidated and the proceeds returned to shareholders.
The fully-subscribed book value of the company is £1 million, the amount of cash
offered for the shares. However, this takes no account of the investment returns likely
to be generated by Navenby. In the prospectus inviting investors to subscribe, the company announced details of its £1 million investment programme. It has concluded a
deal with a builder to purchase a block of properties on very attractive terms, as well
as instructing a letting agency to rent out the properties at a guaranteed income of
£130,000 p.a. Based upon past property price movements, Navenby’s management estimate 70 per cent capital appreciation over the five-year period. All net income flows
(after management fees of £30,000 p.a.) will be paid out as dividends.
In the absence of risk and taxation, Navenby is easy to value. Its value is the sum of
discounted future expected cash flows (including the residual asset value) from the
project i.e. (£130,000 – £30,000) p.a., plus the eventual sale proceeds:
Year
Net rentals p.a. (£m)
Sale proceeds (£m)
1
2
3
4
5
0.1
0.1
0.1
0.1
0.1
1.7
If shareholders require, say, a 12 per cent return for an activity of this degree of risk,
the present value (PV) of the project is found using the relevant annuity (PVIFA) and
single payment (PVIF) discount factors, introduced in Chapter 3, as follows:
PV (£0.1 m PVIFA(12,5)) (£1.7 m PVIF(12,5))
(£0.1 m 3.6048) (£1.7 m 0.5674)
(£0.361 m £0.964 m) £1.325 m
The value of the company is £1.325 million and shareholders are better off by £0.325
million. In effect, the managers of Navenby are offering to convert subscriptions of
£1 million into cash flows worth £1.325 million. If there is general consensus that these
figures are reasonable estimates, and if the market efficiently processes new information, then Navenby’s share price should be £1.325 m/1 m £1.325 when information
about the project is released. If so, Navenby will have created wealth of £0.325 million
for its shareholders.
Self-assessment activity 4.4
Navenby has a value of £1.325 million, but a major part of this reflects the eventual resale
value of the assets. What final asset value would enable investors to just break even?
(Answer in Appendix A at the back of the book)
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The general valuation model (GVM)
general valuation model
A family of valuation models
that rely on discounting future
cash flows to establish the
value of the equity or the
whole enterprise
In analysing Navenby, we applied the general valuation model, which states that the value
of any asset is the sum of all future discounted net benefits expected to flow from the asset:
n
Xt
Vo a
t
t0 11 ke 2
where Xt is the net cash inflow or outflow in year t, ke is the rate of return required by
shareholders and n is the time period over which the asset is expected to generate
benefits.
It should be noted that for a newly-formed company, such as Navenby, the valuation expression can be written in two ways:
value cash subscription NPV of proposed activities
or
value present value of all future cash inflows less outflows
These are equivalent expressions. The value of Navenby is £1.325 million, and the
net present value of the investment is £0.325 million, i.e. it would be rational to pay up
to £0.325 million to be allowed to undertake the investment opportunity. Valuation of
Navenby is relatively straightforward partly because the company has only one activity, but primarily because most key factors are known with a high degree of precision
(although not the residual value). In practice, future company cash flows and dividends are far less certain.
■
The oxygen of publicity
Many corporate managers are somewhat parsimonious in their release of information to
the market. Their motives are often understandable, such as reluctance to divulge commercially sensitive information. As a result, many valuations are largely based on inspired
guesswork. The value of a company quoted on a semi-strong efficient share market can
only be the product of what information has been released, supplemented by intuition.
Yet company chairpeople are often heard to complain that the market persistently
undervalues ‘their’ companies. Some, for example Richard Branson (Virgin) and
Andrew Lloyd-Webber (Really Useful Group), in exasperation, even mounted buyback operations to repurchase publicly held shares. The ‘problem’, however, is often
of their own making. The market can only absorb and process that information which
is offered to it. Indeed, information-hoarding may even be interpreted adversely. If
information about company performance and future prospects is jealously guarded,
we should not be surprised when the valuation appears somewhat enigmatic.
4.7
THE DCF APPROACH
The previous section implies that we should rely on a discounted cash flow approach.
After all, it is rational to attach value to future cash proceeds rather than to accounting
earnings, which are based on numerous accounting conventions, including the deduction
of a non-cash charge for depreciation. Given that depreciation is not a cash item, surely
all we need do is to take the reported profit after tax (PAT) figure and add back depreciation to arrive at cash flow and then discount accordingly?
As a first approximation, we could thus value a company by valuing the stream of
annual cash flows as measured by:
Cash flow (operating profit depreciation)
(cash revenues cash operating costs)
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The depreciation charge is added back because it is merely an accounting adjustment to reflect the fall in value of assets. If firms did replace capacity as it expired, in
principle, this investment should equate to depreciation. In practice, however, only
by coincidence does the annual depreciation charge accurately measure the annual
capital expenditure required to maintain production, and thus earnings capacity.
Moreover, most companies need investment funds for growth purposes as well as for
replacement. The value of growing companies depends not simply on the earning
power of their existing assets, but also on their growth potential; in other words, the
NPV of the cash flows from all future non-replacement investment opportunities.
This suggests a revised concept of cash flow. To obtain an accurate assessment of
value, we should assess total ongoing investment needs and set these against anticipated revenue and operating cost flows; otherwise we might over-value the company.
■
Valuation and free cash flow (FCF)
The inflow remaining net of investment outlays is referred to as free cash flow (i.e.
‘free’ of investment expenditure).
Free cash flow [revenuesoperating costs] [interest payments] [taxes]
[depreciation][investment expenditure]
Using this measure, the value of the owners’ stake in a company is the sum of future
discounted free cash flows:
n
FCF
Vo a
t
t1 11 ke 2
This approach removes the problem of confining investment financing to retentions, as in the Dividend Growth Model (see below). However, we encounter significant forecasting problems in having to assess the growth opportunities and their
financing needs in all future years.
Unfortunately, the accounting data for revenues and operating costs upon which this
approach is based may fail to reflect cash flows due to movements in the various items
of working capital. For example, a sales increase may raise reported profits, but if made
on lengthy credit terms, the effect on cash flow is delayed. Indeed, the net effect may be
negative if suppliers of additional raw materials insist on payment before debtors settle.
It is important to mention another distortion. Stock-building, either in advance of
an expected sales increase or simply through poor inventory control, can seriously
impair cash flow, although the initial impact on profit reflects only the increased stockholding costs.
For these and similar reasons, accurate estimation of cash flow involves forecasting not
merely all future years’ sales, relevant costs and profits, but also all movements in working capital. Alternatively, one may assume that these factors will have a net cancelling
effect, which may be reasonable for longer-term valuations but much less appropriate for
short time-horizon valuations, as in the case of high-risk activities. Figure 4.1 provides a
schema to show the calculation of FCF, and how it relates to other cash flow concepts.
Self-assessment activity 4.5
What is the free cash flow for the following firm?
Operating Profit (after depreciation of £2 m)
£25 m
Interest paid
£1 m
Tax rate
30%
Investment expenditure
£3 m
(Answer in Appendix A at the back of the book)
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102 Part I A framework for financial decisions
1 Operating Profit
PLUS
EBITDA
2 Depreciation
NET CASH
FLOW FROM
OPERATING
ACTIVITIES
PLUS/MINUS
3 Changes in Working Capital
LESS
4 Interest Payments
LESS
5 Tax Payments
LESS
6 Capital Expenditure
EQUALS
7 FREE CASH FLOW
Notes :
Figure 4.1
Calculating free cash
flow (FCF)
■
1 + 2 is roughly equivalent to EBITDA.
1 + 2 + 3 corresponds to ‘Net Cash Flow from Operating Activities’
found on a UK firm’s Cash Flow Statement.
Item 6 is sometimes confined to Replacement Capital Expenditure.
A warning!
The term ‘free cash flow’ is used in a wide variety of ways in practice. Here, we use it
to signify cash left in the company after meeting all operating expenditures, all
mandatory expenditures such as tax payments, and investment expenditure. It focuses on what remains for the directors to spend either as dividend payments, repayment
of debts, acquisition of other companies or simply to build up cash balances. This
broad definition is necessary because the cash inflow figure is defined to include revenues from both existing and future operations. Consequently, the investment expenditure required to generate enhancements in revenue must be allowed for. By the same
token, a growth factor should be incorporated in the operating profit figures to reflect
the returns on this investment.
A narrower definition could be used to confine cash inflows to those relating to
existing operations and investment, and expenditures to those required simply to
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make good wear and tear, i.e. replacement outlays. This has the merit of expressing the
cash flow before strategic investment, over which directors have full discretion. It also
avoids financing complications, e.g. where a company wishes to invest more than its
free cash flows, thus requiring additional external finance, which may distort the actual cash flow figure, as reflected in the cash flow statement.
However, this yields a very restricted, static vision of the business, neglecting the
strategic opportunities and their costs and benefits, which are truly responsible for
imparting a major portion of value in practice. Failure to capture these longer-term
strategic opportunities could yield a valuation well short of the market’s assessment.
The problem of defining free cash flows is compounded by examination of UK
company reports. Listed UK companies are obliged to present cash flow statements
which report the net change in cash and near cash holdings over the year. This is a
backward-looking statement which says more about past liquidity changes than
future cash flows. Some firms do report a figure for ‘free cash flow’, but often without defining it. Jupe and Rutherford (1997) analysed the reports of 222 of the 250
largest listed UK companies. They found that just 21 disclosed a free cash flow figure, although only 14 used the term itself, and few of these supplied either a definition or a breakdown. Analysis of the comments of 13 companies appeared to reveal
the use of 13 different definitions. Clearly, this is an area where care is required in
definition and usage.
4.8
VALUATION OF UNQUOTED COMPANIES
golden handcuffs
An exceptionally good remuneration package paid to executives to prevent them from
leaving
The inexact science of valuing a company or its shares is made considerably simpler if
the firm’s shares are traded on a stock market. If trading is regular and frequent, and if
the market has a high degree of information efficiency, we may feel able to trust market values. If so, the models of valuation merely provide a check, or enable us to assess
the likely impact of altering key parameters such as dividend policy or introducing
more efficient management.
With unquoted companies, the various models have a leading rather than a supporting role, but give by no means definitive answers. Attempts to use the models
inevitably suffer from information deficiencies, which may be only partially overcome. For example, in using a P:E multiple, a question arises concerning the appropriate P:E ratio to apply. Many experts advocate using the P:E ratio of a ‘surrogate’
quoted company, one that is similar in all or most respects to the unquoted subject.
One possible approach is to take a sample of ‘similar’ quoted companies, and find a
weighted average P:E ratio using market capitalisations as weights.
However, the shares of a quoted company are, by definition, more marketable
than those of unquoted firms, and marketability usually attracts a premium, suggesting a lower P:E ratio for the unquoted company. Any adjustment for this factor
is bound to be arbitrary, and different valuation experts might well apply quite different adjustment factors.
Furthermore, a major problem in valuing and acquiring unquoted companies is the
need to tie in the key managers for a sufficient number of years to ensure the recovery
of the investment. The cost of such ‘earn-outs’, or ‘golden handcuffs’, could be a major
component of the purchase consideration.
In principle, all the valuation approaches explained in this chapter are applicable to
valuing unquoted companies, so long as suitable surrogates can be found, or if reliable
industry averages are available. If surrogate data cannot be used, valuation becomes
even more subjective. In these circumstances, it is not unusual to find valuers convincing themselves that company accounts are objective and reliable indicators of
value. While accounts may offer a veneer of objectivity, we need hardly repeat the pitfalls in their interpretation.
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104 Part I A framework for financial decisions
4.9
VALUING SHARES: THE DIVIDEND VALUATION MODEL
The Navenby example (discussed in Section 4.6) demonstrates why investors purchase and hold ordinary shares. Shareholders attach value to shares because they
expect to receive a stream of dividends and hope to make an eventual capital gain.
However, Navenby was a special case because it proposed to pay out all its earnings
as dividend – few companies do this in reality. Although shareholders are legally
entitled to the earnings of a company, in the case of a company with a dispersed ownership body, their influence on the dividend payout is limited by their ability to exert
their voting power on the directors. Other things being equal, shareholders prefer
higher to lower dividends, but issues such as capital investment strategy and taxation
may cloud the relationship between dividend policy and share value. With this reservation in mind, we now develop the Dividend Valuation Model (DVM). This is
appropriate for valuing part shares of companies rather than whole enterprises. This
is because minority shareholders have little or no control over dividend policy and
thus it is reasonable to project past dividend policy, especially as companies and their
owners are known to prefer a steadily rising dividend pattern rather than more erratic payouts. Conversely, if control changes hands, the new owner can appropriate the
earnings as it chooses.
■
Valuing the dividend stream
The DVM states that the value of a share now, Po, is the sum of the stream of future discounted dividends plus the value of the share as and when sold, in some future year, n:
Po D3
Dn
Pn
D2
D1
p
n 2
3
11 ke 2
11 ke 2
11 ke 2 n
11 ke 2
11 ke 2
However, since the new purchaser will, in turn, value the stream of dividends after
year n, we can infer that the value of the share at any time may be found by valuing
all future expected dividend payments over the lifetime of the firm. If the lifespan is
assumed infinite and the annual dividend is constant, we have:
q
Dt
D1
Po a
,
t ke
t1 11 ke 2
where D1 D2 D3 etc.
This is an application of valuing a perpetuity, the mathematics of which were
explained in Appendix III to Chapter 3.
For example, the shares of a company whose owners require a return of 15 per cent,
and which is expected to pay a constant annual dividend of 30p per share through
time would be valued thus:
Po 30p
0.15
£2.00 per share
In reality, the assumptions underlying this basic model are suspect. The annual dividend is unlikely to remain unchanged indefinitely, and it is difficult to forecast a varying stream of future dividend flows. To a degree, the forecasting problem is moderated
by the effect of applying a risk-adjusted discount rate because more distant dividends
are more heavily discounted. For example, discounting at 20 per cent, the present
value of a dividend of £1 in 15 years’ time is only 6p, while £1 received in 20 years adds
only 3p to the value of a share. In other words, for a plausible cost of equity, we lose
little by assuming a time-horizon of, say, 15 years. Even so, reliable valuations still
require estimates of dividends over the intervening years, and by the same token, any
errors will have a magnified effect during this period.
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105
Allowing for future dividend growth
Dividends fluctuate over time, largely because of variations in the company’s fortunes,
although most firms attempt to grow dividends more or less in line with the company’s
longer-term earnings growth rate. For reasons explained in Chapter 17, financial managers attempt to ‘smooth’ the stream of dividends. For companies operating in mature
industries, the growth rate will roughly correspond to the underlying growth rate of the
whole economy. For companies operating in activities with attractive growth opportunities, dividends are likely to grow at a faster rate, at least over the medium term.
■
Allowing for dividend growth: the DGM
The constant dividend valuation model can be extended to cover constant growth thus
becoming the Dividend Growth Model (DGM). This states that the value of a share is
the sum of all discounted dividends, growing at the annual rate g:
Po Do 11 g2
11 ke 2
Do 11 g2 2
11 ke 2
2
Do 11 g2 3
11 ke 2
3
p
Do 11 g2 n
11 ke 2 n
If Do is this year’s recently paid dividend,* Do(1g) is the dividend to be paid in one
year’s time (D1), and so on.
Such a series growing to infinity has a present value of:
Po Do 11 g2
1ke g2
D1
1ke g2
The growth version of the model is often used in practice by security analysts (it is
popularly known as ‘the dividend discount model’), at least as a reference point, but
it makes some key assumptions. Dividend growth is assumed to result from earnings
growth, generated solely by new investment financed by retained earnings. Such
investment is, of course, worthwhile only if the anticipated rate of return, R, is in
excess of the cost of equity, ke. Furthermore, it is assumed that the company will retain
a constant fraction of earnings and invest these in a continuous stream of projects all
offering a return of R. It also breaks down if g exceeds ke. (Problems with the DGM are
discussed in Section 4.10.)
■
Navenby again
To illustrate the growth model, we return to the Navenby example but assume an infinite project life. This requires removal of the asset sale at the end of year 5. Suppose further that, at the end of the first year, it will retain 50 per cent of its earnings and reinvest
these at an expected annual return of 20 per cent, comfortably above the required 12 per
cent. In the next year, earnings would grow at 10 per cent to reach a new level of:
‘original’ cash flow return on reinvested earnings =
new earnings level of £0.1 m 20% (50% £0.1 m) (£0.1 m £0.01 m) £0.11 m
If further retentions of 50 per cent are made at the end of the second year and also
reinvested in further projects offering annual returns of 20 per cent, earnings after
three years will be:
£0.11 m 20% of (50% £0.11 m) (£0.11 m £0.011 m) £0.121 m
and so on. The policy of retention and reinvestment has launched Navenby on an
*If the dividend has recently been paid, i.e. the next dividend will be paid in, say, a year’s time, the shares
are said to be ‘ex-dividend’. They trade without entitlement to a dividend for some considerable time.
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Table 4.3
Year
How earnings and dividends grow in tandem
(figures in £m)
Earnings
Dividends (50%)
1
2
3
4
etc.
0.10
0.05
0.11
0.055
0.121
0.0605
0.1331
0.06655
etc.
etc.
exponential growth path. The dividend growth rate of 10 per cent is a compound of
the retention ratio, denoted by b, and the return on reinvested earnings, R:
g = (b R) = (50% 20%) = 10%
Table 4.3 shows the future behaviour of both earnings and dividends assuming b
and R are constant. Clearly, both magnitudes grow in tandem, so long as the company maintains the same retention ratio (50 per cent).
In Chapter 17, we examine more fully the issues of whether and how a change in
dividend policy can be expected to alter share value. For the moment, we are mainly
concerned with the mechanics of the DGM and rely simply on the assumption that any
retained earnings are used for worthwhile investment. If this applies, the value of the
equity will be higher with retentions-plus-reinvestment than if the investment opportunities were neglected, i.e. the decision to retain earnings benefits shareholders
because of company access to projects that offer returns higher than the owners could
otherwise obtain.
Self-assessment activity 4.6
XYZ plc currently earns 16p per share. It retains 75 per cent of its profits to reinvest at an
average return of 18 per cent. Its shareholders require a return of 15 per cent. What is the
ex-dividend value of XYZ’s shares? What happens to this value if investors suddenly
become more risk-averse by seeking a return of 20 per cent?
(Answer in Appendix A at the back of the book)
4.10
PROBLEMS WITH THE DIVIDEND GROWTH MODEL
The Dividend Growth Model, while possessing some convenient properties, has some
major limitations.
■
What if the company pays no dividend?
The company may be faced with highly attractive investment opportunities that cannot
be financed in other ways. According to the model, such a company would have no
value at all! Total retention is fairly common, either because the company has suffered
an actual or expected earnings collapse, or because, as in some European economies
(e.g. Switzerland), the expressed policy of some firms is to pay no dividends at all. The
American computer software firm Microsoft paid its first dividend only in 2003, while
two other computer firms, Dell and Apple, have yet to pay dividends at all. Yet we
observe that shares in such companies do not have zero values. Indeed, nothing could
be further from the truth.
In the case of Dell, $100 invested in its initial public offering in June 1988, would
have been worth about $38,000 by January 2005 following 100 per cent profits retention. After seven stock splits, 100 shares of Dell was equivalent to 9,600 shares. Apple’s
history is more chequered. It managed to survive the major strategic blunder of omitting
to license out the Macintosh operating system to other manufacturers. Having gone
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107
public in 1980 at an issue price of $22, its share price plummeted to $7 in 1998, soaring
to nearly $70 in the dotcom bubble before receding to $15 in 2003. However, this firm
is enjoying a ‘second bite at the cherry’ with the spectacular success of the iPod digital music player. Its product, iTunes, registered its 200 millionth download in
December 2004, just ten months after launch, making Apple the world leader in legally downloaded music. During 2004, its shares rose from $20 to $65, including a 20 percent jump in November on the announcement of its first quarter 2004 results.
A distressed company like Apple, in its ‘dog days’, would have a positive value so
long as its management were thought capable of staging a corporate recovery, i.e. the
market is valuing more distant dividends on hopes of a turn-around in earnings. If
recovery is thought unlikely, the company is valued at its break-up value.
For inveterate non-dividend payers, the market is implicitly valuing the liquidating
dividend when the company is ultimately wound up. Until this happens, the company is adding to its reserves as it reinvests, and continually enhancing its assets, its
earning power and its value. In effect, the market is valuing the stream of future earnings that are legally the property of the shareholders.
■
Will there always be enough worthwhile projects in the future?
The DGM implies an ongoing supply of attractive projects to match the earnings available for retention. It is most unlikely that there will always be sufficient attractive projects available, each offering a constant rate of return, R, sufficient to absorb a given
fraction, b, of earnings in each future year. While a handful of firms do have very
lengthy lifespans, corporate history typically parallels the marketing concept of the
product life cycle – introduction, (rapid) growth, maturity, decline and death – with
paucity of investment opportunities a very common reason for corporate demise. It is
thus rather hopeful to value a firm over a perpetual lifespan. However, remember that
the discounting process compresses most of the value into a relatively short lifespan.
■
What if the growth rate exceeds the discount rate?
The arithmetic of the model shows that if g ke, the denominator becomes negative
and value is infinite. Again, this appears nonsensical, but, in reality, many companies
do experience periods of very rapid growth. Usually, however, company growth settles
down to a less dramatic pace after the most attractive projects are exploited, once the
firm’s markets mature and competition emerges. There are two ways of redeeming the
model in these cases. First, we may regard g as a long-term average or ‘normal’ growth
rate. This is not totally satisfactory, as rapid growth often occurs early in the life cycle
and the value computed would thus understate the worth of near-in-time dividends.
Alternatively, we could segment the company’s lifespan into periods of varying growth
and value these separately. For example, if we expect fast growth in the first five years
and slower growth thereafter, the expression for value is:
Po 3Present value of dividends during year 1–54
3Present value of all further dividends 4
Note that the second term is a perpetuity beginning in year 6, but we have to find its
present value. Hence it is discounted down to year zero as in the following expression:
Po Do 11 gf 2
11 ke 2
Do 11 gf 2 2
11 ke 2
2
p
5 D 11 g 2
q D 11 g 2
o
f
5
s
a
t
t
a
t1 11 ke 2
t6 11 ke 2
Do 11 gf 2 5
11 ke 2 5
¢
D5 11 gs 2
1ke gs 2
1
≤
11 ke 2 5
where gf is the rate of fast growth during years 1–5 and gs is the rate of slow growth
beginning in year 6 (i.e. from the end of year 5).
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108 Part I A framework for financial decisions
The DGM may be used to examine the impact of changes in dividend policy, i.e.
changes in b. Detailed analysis of this issue is deferred to Chapter 17.
Example: the case of unequal growth rates
Consider the case of dividend growth of 25 per cent for years 1–5 and 7 per cent thereafter.
Assuming shareholders require a return of 10 per cent, and that dividend in year zero is 10p,
the value of the share is calculated as follows:
For years 1–5
Year
1
2
3
4
5
Dividend (p)
Discount factor at 10%
PV (p)
10(1.25)
12.5
12.50(1.25)2 15.6
etc.
19.5
24.4
30.5
0.909
0.826
0.751
0.683
0.621
11.4
12.9
14.6
16.7
18.9
74.5
Total
For later years, we anticipate a perpetual stream growing from the year 5 value at 7 per cent
p.a. The present value of this stream as at the end of year 5 is:
30.5p11.072
32.64p
D5 11 7%2
D6
£10.88
ke gs
110% 7%2
0.03
0.03
This figure, representing the PV of all dividends following year 5, is now converted into a
year zero present value:
PV £10.88 (PVIF10.5) (£10.88 0.621) £6.76
Adding in the PV of the dividends for the first five years, the PV of the share right now is:
PV (£0.745 £6.76) £7.51
However, we may note here that valuation of the dividend stream implies a known
dividend policy. Because dividends are not controlled by shareholders, but by the
firm’s directors, the DGM is more applicable to the valuation of small investment
stakes in companies than to the valuation of whole companies, as in takeover situations. When company control changes hands, control of dividend policy is also transferred. It seems particularly unrealistic, therefore, to assume an unchanged dividend
policy when valuing a company for takeover.
■
The P:E ratio and the Constant Dividend Valuation Model
earnings yield
The earnings per share (EPS)
divided by market share price
If we examine the P:E ratio more closely, we find it has a close affinity with the growth
version of the DVM. The P:E ratio is defined as price per share (PPS) divided by earnings
per share (EPS). In its reciprocal form, it measures the earnings yield of the firm’s shares:
Earnings
EPS
E
1
P:E
PPS
Company value
V
This equals the dividend yield plus retained earnings (bE) per share. As in the
DGM, the growth version of the DVM, we define the fraction of earnings retained as
b. We can then write:
E
D
bE
V
V
V
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Chapter 4 Valuation of assets, shares and companies
109
The ratio E/V is the overall rate of return currently achieved. If this equals R, the rate
of return on reinvested funds, then bE/V is equivalent to the growth rate g in the DGM.
In other words, the earnings yield, E/V, comprises the dividend yield plus the growth
rate or ‘capital gains yield’ for a company retaining a constant fraction of earnings and
investing at the rate R. The two approaches thus look very similar. However, this
apparent similarity should not be over-emphasised for three important reasons:
1 The earnings yield is expressed in terms of the current earnings, whereas the DGM
deals with the prospective dividend yield and growth rate, i.e. the former is historic
in its focus, while the latter is forward-looking.
2 The DGM relies on discounting cash returns, while the earnings figure is based on
accounting concepts. It does not follow that cash flows will coincide with accounting profit, not least due to depreciation adjustments.
3 For the equivalence to hold, the current rate of return, E/V, would have to equal the
rate of return expected on future investments.
Despite these qualifications, it is still common to find the earnings yield presented
as the rate of return required by shareholders, and hence the cut-off rate for new
investment projects. Unfortunately, this confuses a historical accounting measure with
a forward-looking concept.
4.11
SHAREHOLDER VALUE ANALYSIS
During the 1980s, based on the work of Rappaport (1986), an allegedly new approach
to valuation emerged, called shareholder value analysis (SVA). In fact, it is not really
novel, but a rather different way of looking at value, based on the NPV approach.
The key assumption of SVA is that a business is worth the net present value of its
future cash flows, discounted at the appropriate cost of capital. Many leading US corporations (e.g. Westinghouse, Pepsi and Disney) and a growing number of European
companies (e.g. Philips, Siemens) have embraced SVA because it provides a framework for linking management decisions and strategies to value creation. The focus is
on how a business can plan and manage its activities to increase value for shareholders and, at the same time, benefit other stakeholders.
How is this achieved? Figure 4.2 shows the relationship between decision-making
Corporate
objective
SHAREHOLDER VALUE
Cash flow from
operations
Value
drivers
Figure 4.2
Shareholder value
analysis framework
Strategic
focus
Sales growth
Margin
Planning horizon
Business
strategy
Cost of
capital
Capital investment
Working capital
Acquisitions
Investment
strategy
Credit rating
Tax rate
Capital structure
Dividend policy
Financing
strategy
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110 Part I A framework for financial decisions
value drivers
Factors that have a powerful
influence on the value of a
business, and the investors’
equity stake
and shareholder value. Key decisions – whether strategic, operational, investment or
financial – with important cash flow and risk implications are specified. Managers
should focus on decisions influencing the value drivers, the factors that have greatest
impact on shareholder value. Typically, these include the following:
1 Sales growth and margin. Sales growth and margins are influenced by competitive
forces (e.g. threat of new entrants, power of buyers and suppliers, threat of substitutes and competition in the industry). The balance between sales, growth and profits should be based not only on profit impact, but also on value impact.
2 Working capital and fixed capital investment. Over-emphasis on profit, particularly at
the operating level, may result in neglect of working capital and fixed asset management. In Section 4.7, the free cash flow approach advocated using cash flows
after meeting fixed and working capital requirements.
3 The cost of capital. A firm should seek to make financial decisions that minimise the
cost of capital, given the nature of the business and its strategies. As will be seen
later, this does not simply mean taking the source of finance that is nominally the
cheapest.
4 Taxation is a fact of business life, especially as it affects cash flows and the discount
rate. Managers need to be aware of the main tax impact on both investment and
financial decisions.
SVA requires specification of a planning horizon, say, five or ten years, and forecasting the cash flows and discount rates based on the underlying plans and strategies.
Various strategies can then be considered to assess the implications for shareholder
value.
A particular problem with SVA is specifying the terminal value at the end of the
planning horizon. One approach is to try to predict the value of all cash flows
beyond the planning horizon, based on that of the final year. Another is to simply
take the value of the net assets predicted at the end of the horizon. None of the
methods suggested is wholly satisfactory. It could be argued, however, that SVA
does not have to be used to obtain the value of the business – rather, it can estimate
the additional value created from implementing certain strategies. Assuming these
strategies deliver competitive advantage, and therefore returns in excess of the cost
of capital over the planning horizon, there is no need to wrestle with the terminal
value problem.
The real benefit of SVA is that it helps managers focus on value-creating activities.
Acquisition and divestment strategies, capital structure and dividend policies, performance measures, transfer pricing and executive compensation are seen in a new
light. Short-term profit-related activities may actually be counter-productive in valuecreation terms.
Balti plc: a simple example of SVA
Balti plc is a food manufacturer with a stock market listing. Its shareholders require a return
of 12 per cent. It has just determined its free cash flow for the year at £100,000, as shown in
the first table below.
Depreciation is £75,000 p.a., rather less than capital expenditure of £125,000 p.a. Extra
investment in working capital to support growth plans is £50,000 p.a.
The free cash flows for years 2–5 of its five-year planning horizon are predicted similarly at £150,000, £170,000, £230,000 and £250,000 respectively. Its net asset value after five
years is predicted to be £2.5 million.
The calculation of the value of the firm to its shareholders (i.e. SV) is shown in the second table. The SV is the NPV of all future free cash flows, calculated at £2,036,500.
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Chapter 4 Valuation of assets, shares and companies
Forecast data for Year 1
less
less
add
less
less
Sales
Operating costs
Pre-tax profit
Tax paid
Net operating profit after tax
Depreciation
Fixed capital investment
Additional working capital
Free cash flow
£000
Value drivers
900
(600)
300
(100)
200
75
(125)
(50)
100
Sales growth
111
Margin
Tax rate
Capital expenditure
Working capital investment
Calculation of shareholder value:
Forecast cash flows £000
NPV@12%
Yr1
Yr2
Yr3
Yr4
Yr5
100
150
170
230
250
Terminal Value
£617,900
PV terminal value £1,418,600
Total NPV
£2,036,500 Shareholder Value
2,500,000
Self-assessment activity 4.7
Determine the impact on Balti’s SV if it is able to invest £0.3 million now in order to
extend its competitive advantage period to ten years. Assume free cash flow for years
6–10 stabilises at £250,000 p.a. and that the terminal value in year 10 is £4 million.
(Answer in Appendix A at the back of the book)
4.12
ECONOMIC VALUE ADDED (EVA)
Along with SVA comes another piece of ‘alphabet spaghetti’, EVA, a concept trademarked by the US consultancy house Stern Stewart (www.sternstewart.com).
Whereas SVA is a forward-looking technique devised for assessing the inherent
value of the equity invested in a firm, EVA is backward-looking, i.e. a measure of
performance. Like SVA, EVA relies heavily on the concept of the cost of capital. It is
used as a device for assessing how much value or wealth a firm actually has created. Its roots lie in the accounting concept of Residual Income (e.g. see Horngren et
al. 1998), which is simply the accounting profit adjusted for the cost of using the
capital tied up in an activity.
However, the Stern Stewart version is rather more sophisticated as it attempts to
adjust the recorded profit in various ways. The logic of these adjustments is, broadly,
to avoid recording as a cost the items that are value-creating and that should perhaps
be treated as capital rather than current expenditure. For example, spending on R & D
and on product advertising and promotion contributes to wealth-creation in important ways. In addition, any goodwill that has been written off in relation to previous
acquisitions is added back. The general impact of these adjustments – over 150 of these
might be required in a full EVA calculation – is to raise the profit measure and also the
capital employed.
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112 Part I A framework for financial decisions
Table 4.4
Calculation of EVA
Firm A
Firm B
NOPAT
£20 m
£10 m
Equity
£100 m
£100 m
ke
15%
15%
EVA
£20 m £15 m £5 m
£10 m £15 m (£5 m)
Relating this to an all-equity-financed firm, EVA is calculated after making a further
adjustment for the opportunity cost incurred by shareholders when entrusting their
capital to the firm’s directors. The EVA formula can be written as:
EVA NOPAT (ke invested capital)
where:
NOPAT the Net Operating Profit After Tax, and after adjustment for the items
mentioned above
ke the rate of return required by shareholders
Invested capital Net Assets, or Shareholders’ Funds
To illustrate the concept, consider the data in Table 4.4.
Both firms have the same equity capital employed of £100 m, and both make positive accounting profits. However, after adjusting for the cost of the equity capital
employed, Firm B has effectively made a loss for investors, i.e. the negative EVA indicates that it has destroyed value.
On the face of it, EVA is a simple and powerful tool for assessing performance,
explaining why it has been adopted by many firms as an internal performance measurement device, e.g. for determining the performance of different operating units.
However, it is by no means problem-free:
1 Few firms have the resources required to compute EVA, division by division, with
the same degree of rigour as the full Stern Stewart model with its myriad required
adjustments.
2 It is based on book value, rather than market values (necessarily so for business
segments).
3 It relies on a fair and reliable way allocating shared overheads across business units,
the Holy Grail of management accountants.
4 It is difficult to identify the cost of capital for individual operating units.
5 It may be dysfunctional if managers are paid according to EVA, especially short-term
EVA. It is quite possible to encounter investment projects that flatter EVA in the short
term by virtue of high initial cash flows but to have a negative NPV. Such projects
might be favoured by managers who are paid by EVA. Similarly, some long-term
projects that take time and money to develop may lower EVA in the early years but
have a positive NPV. These, of course, could be rejected under an EVA regime.
The verdict is yet to be delivered on EVA, but like many other management tools, it
is probably inadequate when used alone – it is one way of looking at the picture that
should be supplemented by other perspectives.
SUMMARY
We have discussed the reasons why financial managers may wish to value their own
and other enterprises, the problems likely to be encountered and the main valuation
techniques available.
Given the uncertainties involved in valuation, it seems sensible to compare the
implications of a number of valuation models and to obtain valuations from a number
of sources. A pooled valuation is unlikely to be correct, but armed with a range of
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113
valuations, managers should be able to develop a likely consensus valuation. This consensus is, after all, what a market value represents, based upon the views of many
times more market participants. There should be no stigma attached to obtaining more
than one opinion–doctors do not hesitate to call for second opinions when unsure
about medical diagnoses.
Key points
■
An understanding of valuation is required to appreciate the likely effect of investment and financial decisions, to value other firms for acquisition, and to organise
defences against takeover.
■
Valuation is easier if the company’s shares are quoted. The market value is ‘correct’
if the EMH applies, but managers may have withheld important information.
■
Using published accounts is fraught with dangers, e.g. under-valuation of fixed
assets.
■
Some companies attempt to value the brands they control. An efficient capital market will already have valued these, but not necessarily in a fully informed manner.
■
The economic theory of value tells us that the value of any asset is the sum of the
discounted benefits expected to accrue from owning it.
■
A company’s earnings stream can be valued by applying a P:E multiple, based upon
a comparable, quoted surrogate company.
■
Some observers like to compare the EBITDA (Earnings Before Interest, Tax
Depreciation and Amortisation) with share price for different companies as a
cross-check on valuation. Market-based EBITDA multiples can be used as valuation tools.
■
Valuing a company on a DCF basis requires us to forecast all future investment capital needs, tax payments and working capital movements.
■
Valuation of unquoted companies is highly subjective. It requires examination of
similar quoted companies and applying discounts for lack of marketability.
■
The value of a share can be found by discounting all future expected dividend
payments.
■
The retention of earnings for worthwhile investment enhances future earnings, dividends and, therefore, the current share price.
■
The Dividend Valuation Model must be treated with caution. It embodies many
critical assumptions.
■
Economic Value Added (EVA) is the residual profit after allowing for the charge for
the firm’s use of investors’ capital.
■
The two main lessons of valuation are: use a variety of methods (or consult a variety of experts) and don’t expect to get it exactly right.
Further reading
Comprehensive treatments of share and company valuation are quite rare: Koller et al. (2004) is
probably the best available. A good overview can be found in Chapter 15 (the contribution by
Davies) of Firth and Keane (1986).
The brand valuation issue is addressed by Murphy (1989) and Barwise et al. (1989).
Young (1997) provides a practical application of the EVA concept.
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114 Part I A framework for financial decisions
QUESTIONS
Questions with a coloured number have solutions in Appendix B on page 693.
1 Amos Ltd has operated as a private limited company for 80 years. The company is facing increased competition and it has been decided to sell the business as a going concern.
The financial situation is as shown on the balance sheet:
Balance Sheet as at 30 June 1999
£
£
Fixed assets
Premises
Equipment
Investments
Current assets
Stock
Debtors
Bank
£
500,000
125,000
50,000
675,000
85,000
120,000
25,000
230,000
Creditors: amounts due within one year
Trade creditors
Dividends
(65,000)
(85,000)
(150,000)
Net current assets
Total assets less current liabilities
Creditors: amounts due after one year
Secured loan stock
Net assets
80,000
755,000
(85,000)
670,000
Financed by
Ordinary shares (50p par value)
Reserves
Profit and loss account
Shareholders’ funds
500,000
55,000
115,000
670,000
The current market values of the fixed assets are estimated as:
Premises
Equipment
Investments
780,000
50,000
90,000
Only 90 per cent of the debtors are thought likely to pay.
Required
Prepare valuations per share of Amos Ltd using:
(i) Book value basis
(ii) Adjusted book value
2 The Board of Directors of Rundum plc are contemplating a takeover bid for Carbo Ltd, an unquoted company which operates in both the packaging and building materials industries. If the offer is successful, there are
no plans for a radical restructuring or divestment of Carbo’s assets.
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115
Carbo’s Balance Sheet for the year ending 31 December 2005 shows the following:
£m
Assets employed
Freehold property
Plant and equipment
Current assets:
stocks
debtors
cash
Total assets
Creditors payable within one year
Total assets less current liabilities
Creditors payable after one year
Net assets
Financed by
Ordinary share capital (25p par value)
Revaluation reserve
Profit and loss account
Shareholders’ funds
£m
4.0
2.0
1.5
3.0
0.1
4.6
10.6
(3.0)
7.6
(1.0)
6.6
2.5
0.5
3.6
6.6
Further information:
(a) Carbo’s pre-tax earnings for the year ended 31 December 2005 were £2.0 million.
(b) Corporation Tax is payable at 33 per cent.
(c) Depreciation provisions were £0.5 million. This was exactly equal to the funding required to replace
worn-out equipment.
(d) Carbo has recently tried to grow sales by extending more generous trade credit terms. As a result, about
a third of its debtors have only a 50 per cent likelihood of paying.
(e) About half of Carbo’s stocks are probably obsolete with a resale value as scrap of only £50,000.
(f) Carbo’s assets were last revalued in 1994.
(g) If the bid succeeds, Rundum will pay off the presently highly overpaid Managing Director of Carbo for
£200,000 and replace him with one of its own ‘high-flyers’. This will generate pre-tax annual savings of
£60,000 p.a.
(h) Carbo’s two divisions are roughly equal in size. The industry P:E ratio is 8:1 for packaging and 12:1 for
building materials.
Required
(a) Value Carbo using a net asset valuation approach.
(b) Value Carbo using a price:earnings ratio approach.
3 Lazenby plc has been set up to exploit an opportunity to import a new product from overseas. It has issued
two million ordinary shares of par value 25p, sold at a 25 per cent premium. Its projected accounts show the
following annual operating figures:
Sales revenue
Operating costs
(after depreciation of £50,000)
Operating profit
Taxation @ 30%
Profit after tax
£500,000
(£300,000)
£200,000
(£60,000)
£140,000
Notes:
(i) Shareholders require a return of 10 per cent p.a.
(ii) Replacement investment is financed out of depreciation provisions and is fully tax-allowable.
(iii) 2% of sales should be written off as bad debts.
(iv) Bad debt write-offs are 50 per cent tax-allowable.
Continued
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116 Part I A framework for financial decisions
Required
Value each share in Lazenby:
(a) assuming perpetual life.
(b) over a ten-year horizon.
4 Brosnan plc generates free cash flows of £5 million p.a. after allowing for tax and depreciation, which is used
for reinvestment. It has issued 10 million shares. Shareholders require a 12 per cent return.
Required
Value each share:
(i) assuming all free cash flows are distributed as dividend.
(ii) assuming 50 per cent of FCFs are retained, with a return on retained earnings of 15 per cent.
(iii) as for (ii), but assuming 10 per cent return on reinvestment.
(iv) assuming that FCFs grow at 7.5 per cent for each of the first three future years, then at 5 per cent thereafter.
Note: assume all cash flows are perpetuities.
5 Insert the missing values in the following table:
(i)
(ii)
(iii)
(iv)
(v)
(vi)
(vii)
Po
Do
£8.44
£4.98
?
£2.75
£10.20
£0.60
£1.47
£0.35
£0.20
£0.10
?
£0.60
£0.05
£0.12
D1
?
£0.219
£0.108
£0.220
£0.610
£0.054
£0.133
g
b
R
ke
8.5%
?
8.0 %
10.0 %
2.0 %
8.0 %
10.5%
0.5
0.6
0.4
0.5
?
0.8
0.7
17%
16%
20%
20%
10%
20%
?
13.0 %
14.0 %
15.0 %
18.0 %
8.0 %
?
19.5%
Note: answers may have some minor rounding errors.
6 Leyburn plc currently generates profits before tax of £10 million, and proposes to pay a dividend of £4 million out of cash holdings to its shareholders. The rate of Corporation Tax is 30 per cent. Recent dividend
growth has averaged 8 per cent p.a. It is considering retaining an extra £1 million in order to finance new
strategic investment. This switch in dividend policy will be permanent, as management believe that there will
be a stream of highly attractive investments available over the next few years, all offering returns of around
20 per cent after tax. Leyburn’s shares are currently valued ‘cum-dividend’. Shareholders require a return of
14 per cent. Leyburn is wholly equity-financed.
Required
(a) Value the equity of Leyburn assuming no change in retention policy.
(b) What is the impact on the value of equity of adopting the higher level of retentions? (Assume the new
payout ratio will persist into the future.)
7 The most recent Balance Sheet for Vadeema plc is given below. Vadeema is a stock market-quoted company
that specialises in researching and developing new pharmaceutical compounds. It either sells or licenses its
discoveries to larger companies, although it operates a small manufacturing capability of its own, accounting
for about half of its turnover:
Balance Sheet as at 30 June 2005
Assets employed
Fixed assets
Tangible
Intangible
Current assets
Stock and work in progress
Debtors
Bank
Current liabilities
Trade creditors
Bank overdraft
£m
£m
50
120
£m
170
80
20
5
105
(10)
(20)
(30)
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Chapter 4 Valuation of assets, shares and companies
Net current assets
10% loan stock
Net assets
Financed by
Ordinary shares capital (25p par value)
Share premium account
Revenue reserves
Shareholders’ funds
75
(40)
205
100
50
55
205
Further information:
1 2004–05, Vadeema made sales of £300 million, with a 25 per cent net operating margin (i.e. after depreciation but before tax and interest).
2 The rate of corporate tax is 33 per cent.
3 Vadeema’s sales are quite volatile, having ranged between £150 million and £350 million over the previous five years.
4 The tangible fixed assets have recently been revalued (by the directors) at £65 million.
5 The intangible assets include a major patent (responsible for 20 per cent of its sales) which is due to expire
in April 2006. Its book value is £20 million.
6 50 per cent of stocks and work-in-progress represents development work for which no firm contract has
been signed (potential customers have paid for options to purchase the technology developed).
7 The average P:E ratio for quoted drug research companies at present is 22:1 and for pharmaceutical manufacturers is 14:1. However, Vadeema’s own P:E ratio is 20:1.
8 Vadeema depreciates tangible fixed assets at the rate of £5 million p.a. and intangibles at the rate of £25 million p.a.
9 The interest charge on the overdraft was 12 per cent.
10 Annual fixed investment is £5 million, none of which qualifies for capital allowances:
Required
(a) Determine the value of Vadeema using each of the following methods:
(i) net asset value
(ii) price:earnings ratio
(iii) discounted cash flow (using a discount rate of 20 per cent)
(b) How can you reconcile any discrepancies in your valuations?
(c) To what extent is it possible for the Stock Market to arrive at a ‘correct’ valuation of a company like Vadeema?
Practical assignment
Obtain the latest annual report and accounts of a company of your choice.* Consult the Balance Sheet and determine the company’s net asset value.
■
■
■
■
■
What is the composition of the assets, i.e. the relative size of fixed and current assets?
What is the relative size of tangible fixed and intangible fixed assets?
What proportion of current assets is accounted for by stocks and debtors?
What is the company’s policy towards asset revaluation?
What is its depreciation policy?
Now consult the financial press to assess the market value of the equity. This is the current share price times the
number of ordinary shares issued. (The notes to the accounts will indicate the latter.)
■
■
■
■
■
■
What discrepancy do you find between the NAV and the market value?
How can you explain this?
What is the P:E ratio of your selected company?
How does this compare with other companies in the same sector?
How can you explain any discrepancies?
Do you think your selected company’s shares are under- or over-valued?
* Most large companies post their Annual Reports and Accounts on their websites. The commonest address forms of UK companies
are: companyname.co.uk or companyname.com.
117
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Part
II
INVESTMENT DECISIONS
AND STRATEGIES
Chapters 5 to 7 examine in depth the investment decision and how it is evaluated. The concepts of
time-value of money and present value are extensively applied. The available methods for assisting
the financial manager to evaluate investment proposals are examined in Chapter 5, both when
capital is freely available and when it is in short supply. Methods of appraisal that do not utilise
discounting procedures are also examined.
In Chapter 6, investment appraisal procedures are applied to practical situations, incorporating the
impact of both taxation and inflation. Consideration is given to identifying the relevant information
for project evaluation, particularly for replacement decisions.
Chapter 7 sets the whole project appraisal system in a strategic perspective and explores the wider
aspects of the investment appraisal system within companies. It dispels the notion that investment
analysis hinges solely on methods of appraisal, and it reveals how companies approach their project
evaluations in practice.
Chapter 5
Investment appraisal methods
121
Chapter 6
Project appraisal–applications
147
Chapter 7
Investment strategy and process
173
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5
Investment appraisal methods
Cigarettes can damage your wealth
Cigarette companies have for years looked for the Holy
Grail of a smokeless cigarette. R. J. Reynolds Tobacco,
US maker of Camel and other cigarette brands,
launched a smokeless cigarette called Premier. It spent
£210 million developing and marketing the new product, which had vast wealth-creating potential and was
socially more acceptable to passive smokers.
After test marketing it for several months, the company finally recognised that it had created one of the
biggest new product flops on record. With 400 brands
of cigarette in the USA, launching a new product is
costly and risky. But the idea of a smokeless cigarette
was still seen by the company as worth pursuing and
it began trials on a new smokeless cigarette brand,
Eclipse that heats, rather than burns, tobacco. Since
the earlier flop, however, the market has changed,
with passive smoking becoming a bigger issue. Time
will tell whether the Eclipse cigarette brand is
launched successfully and generates a positive net
present value.
Learning objectives
Having read this chapter, you should have a good grasp of the investment appraisal techniques commonly employed in business, and have developed skills in applying them. Particular attention will be
devoted to the following:
■
The three discounted cash flow approaches – net present value, internal rate of return and profitability index.
■
The underlying strengths and limitations of the above methods.
■
How net present value and internal rate of return methods can be reconciled when they conflict.
■
Non-discounting methods.
■
Analysing investments when capital availability is an important constraint.
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122 Part II Investment decisions and strategies
5.1
INTRODUCTION
We saw in Chapters 3 and 4 how investing in capital projects that offer positive net
present values creates additional wealth for the business and its owners. A major company explains how it employs the NPV approach in assessing capital projects:
We measure all potential projects by their cash flow merit. We then discount projected
cash flows back to present value in order to compare the initial investment cost with a
project’s future returns to determine if it will add incremental value after compensating
for a given level of risk.
There are, however, a number of alternative techniques to the NPV method. The
aim of this chapter is to present the main methods of investment appraisal and to consider their strengths and limitations. In a later chapter, we consider their practical
application in business, large and small.
5.2
CASH FLOW ANALYSIS
The investment decision is the decision to commit the firm’s financial and other
resources to a particular course of action. Confusingly, the same term is often applied
to both real investment, such as buildings and equipment, and financial investment,
such as investment in shares and other securities. While the principles underlying
investment analysis are basically the same for both types of investment, it is helpful for
us to concentrate here on the former category, usually referred to as capital investment.
Our particular emphasis on strategic capital projects concentrates on the allocation of a
firm’s long-term capital resources.
Self-assessment activity 5.1
Investment projects do not only include investment in plant and equipment or buildings.
Think of some other types of capital projects.
(Answer in Appendix A at the back of the book)
■
Cash flow matters more than profit
Managers in business usually view profit as the best measure of performance. It might,
therefore, be assumed that capital project appraisal should seek to assess whether the
investment is expected to be ‘profitable’. Indeed, many firms do use such an approach.
There are, however, many problems with the profit measure for assessing future
investment performance. Profit is based on accounting concepts of income and
expenses relating to a particular accounting period, based on the matching principle.
This means that income receivable and expenses payable, but not yet received or paid,
along with depreciation charges, form part of the profit calculation.
Consider the case of the Oval Furniture Company with expected annual sales from
its new factory of £400,000 and profits of £60,000. In order to stimulate demand, customers are offered two years’ credit. While this decision has no impact on the reported profit, it certainly affects the cash position – no cash flow being received for two
years. Cash flow analysis considers all the cash inflows and outflows resulting from
the investment decision. Non-cash flows, such as depreciation charges and other
accounting policy adjustments, are not relevant to the decision. We seek to estimate the
stream of cash flows arising from a particular course of action and the period in which
they occur.
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Chapter 5 Investment appraisal methods
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123
Timing of cash flows
Project cash flows will usually arrive throughout the year. For example, if we acquire
a machine with a four-year life on 1 January 2007, the subsequent cash flows related
to it may involve the monthly payment purchases and expenses and daily receipt of
cash from customers throughout each year. Strictly speaking, these cash flows
should be identified on a monthly, even daily, basis and discounted using appropriate discount factors.
In practice, to facilitate the use of annual discount tables, cash flows arising during
the year are treated as occurring at the year end. Thus, while the initial outlay is assumed
to occur at the start of the project (frequently termed Year 0), subsequent cash flows are
deemed to arrive later than they actually arise. This has the effect of producing an NPV
slightly lower than the true NPV, assuming that subsequent cash flows are positive.
Decision-making can be viewed as an incremental activity. Businesses generally
operate as going concerns with fairly clear strategies and well-established management processes. Decisions are part of a sequence of actions seeking to move the organisation from its current to its intended position. The same idea is apparent in analysing
projects – the decision-maker must assess how the business changes as a direct result
of selecting the project. Every project can be either accepted or rejected, and it is the
difference between these two alternatives in any time period, t, expressed in cash flow
terms (CFt), that is taken into the appraisal.
Incremental analysis
Project CFt CFt for firm with project CFt for firm without project.
5.3
INVESTMENT TECHNIQUES – NET PRESENT VALUE
Discounted cash flow (DCF) analysis is a family of techniques, of which the NPV method
is just one variant. Two other DCF methods are the internal rate of return (IRR) and the
profitability index (PI) approaches. Many managers prefer to use non-discounting
approaches such as the payback and return on capital methods; others use both approaches. The following example illustrates the various approaches to investment appraisal.
Example: appraising the Lara and Carling projects
Sportsman plc is a manufacturer of sports equipment. The firm is considering whether to
invest in one of two automated processes, the Lara or the Carling, both of which give rise
to staffing and other cost savings over the existing process. The relevant data relating to
each are given below:
Investment outlay (payable immediately)
Year 1 Annual cost savings
2 Annual cost savings
3 Annual cost savings
4 Annual cost savings
Lara (£)
Carling(£)
(40,000)
16,000
16,000
16,000
12,000
(50,000)
17,000
17,000
17,000
17,000
The required return is 14 per cent p.a.
The investment outlays are obviously additional cash outflows, while the annual cost savings are cash flow benefits because total annual expenditures are reduced as a result of the
investment.
Should the company invest in either of the two proposals and if so, which is preferable?
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124 Part II Investment decisions and strategies
The NPV solution
The net present value for the Lara machine is found by multiplying the annual cash flows by
the present-value interest factor (PVIF) at 14 per cent (using the tables) and finding the total,
as shown in Table 5.1. An immediate cash outlay (treated as Year 0) is not discounted as it is
already expressed in present value terms. The same factors could be applied to evaluate the
Carling proposal. However, as the annual savings are constant, it is far simpler to use the
present value interest factor for an annuity (PVIFA) at 14 per cent for four years.
Comparison of the two proposals reveals the following:
1 The Lara machine offers a positive NPV of £4,252, and would increase shareholder wealth.
2 The Carling machine offers a negative NPV of £467 and would reduce value.
3 Given that the proposals are mutually exclusive (i.e. only one is required), the Lara proposal should be accepted.
Table 5.1
Net present value calculations
Cash flow
(£)
Year
Lara proposal
0
1
2
3
4
PVIF at
factor 14%
Outlay
(40,000)
Cost savings
16,000
Cost savings
16,000
Cost savings
16,000
Cost savings
12,000
Net present value at 14%
Carling proposal
Cost savings
Outlay
1
0.87719
0.76947
0.67497
0.59208
£17,000 PVIFA114%, 4 yrs2 2.9137
Why NPV makes sense to shareholders
Year 0
Borrow: machine
1
Pay NPV as dividend
Interest: £44,252 at 14%
2
Less: repayment
(through annual savings)
Interest: £34,447 at 14%
Less: repayment
3
Interest: £23,269 at 14%
Less: repayment
4
Interest: £10,526 at 14%
Less: repayment
(40,000)
14,035
12,312
10,800
7,105
4,252
49,533
(50,000)
(467)
Net present value at 14%
Table 5.2
Present
value (£)
£40,000
£
£4,252
44,252
6,195
50,447
(16,000)
34,447
4,822
39,269
(16,000)
23,269
3,257
26,526
(16,000)
10,526
1,474
12,000
(12,000)
—
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Chapter 5 Investment appraisal methods
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What does an expected NPV of £4,252 from the Lara proposal really mean? The project’s
future cash flows are sufficient for the firm to pay all costs associated with financing the project and to provide an adequate return to shareholders. From the shareholders’ viewpoint, it
means that the firm could borrow £44,252 (the cost plus the NPV) to purchase the machine
and pay out a dividend today of £4,252, and still have sufficient funds from the project to pay
off the interest at 14 per cent p.a. and annual repayments (see Table 5.2).
In practice, it is unlikely that the lender will agree to a repayment schedule that exactly
matches the expected annual cash flows of the project. It is also somewhat imprudent to
pay as a dividend the whole of the expected NPV before the project commences! However,
in theory at least, the proposal creates wealth of £4,252 and the shareholders are that much
better off than they were prior to the decision. Note that we assume that borrowing and
lending rates of interest are the same. We discuss in later chapters how the discount rate is
estimated; suffice it to say that it is the required rate of return that investors can expect on
comparable alternative investment in the market-place.
5.4
INTERNAL RATE OF RETURN
DCF yield
The rate of return that equates
the present value of future cash
flows with the initial investment outlay
Managers frequently ask: ‘What rate of return am I getting on my investment?’ To calculate the correct return, or yield, requires us to find the rate that equates the present
value of future benefits to the initial cash outlay. We call this the internal rate of return
(IRR), or DCF yield.
The IRR is that discount rate, r, which, when applied to project cash flows 1Xt 2, produces a net present value of zero. It is found by solving the equation for r:
n
Xt
a 11 r2 t 0
t0
Where the IRR exceeds the required rate of return 1r 7 k2, the project should be
accepted.
Suppose a savings scheme offers a plan whereby, for an initial investment of £100,
you would receive £112 at the year end. The IRR is thus 12 per cent:
£10011 r2 £112
r 12%
If another scheme offered a single payment of £148 in three years’ time, from an initial investment of £100, the IRR is found by solving:
£10011 r2 3 £148
or
1
£100
0.6757
£148
11 r2 3
Turning to the present-value interest factor (PVIF) table (Appendix C) for three
years and looking for the rate that comes closest to 0.6757, we find that the IRR for the
investment is approximately 14 per cent. The same approach is used to find the IRR
for capital investment, but here the annual cash flows may differ. We find the IRR by
solving for the rate of return at which the present value of the cash inflows equals the
present value of the cash outflows. That is, we have to solve for
Io Xn
X1
X2
p
1r
11 r2 n
11 r2 2
This is the same as finding the rate of return that produces an NPV of zero.
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126 Part II Investment decisions and strategies
In our earlier example, the Lara produced an NPV of £4,252 at 14 per cent. Given a
‘normal’ pattern of cash flows, i.e. an outlay followed by cash inflows, we can see that
as the discount rate increases, the NPV falls. Trial and error will give us the discount
rate that yields a zero NPV.
Trying 18 per cent, as shown in Table 5.3, gives a positive NPV of £976. Trying 20
per cent gives a negative NPV of £510. Clearly the IRR giving a zero NPV falls between
18 and 20 per cent, probably closer to 20 per cent. Using linear interpolation, we estimate the IRR by applying the formula:
IRR r1 a
N1
1r2 r1 2 b
N1 N2
where r1 is the rate of interest and N1 the NPV for the first guess, and r2 and N2, the NPV
for the second guess. Applying the formula:
IRR 18% a
£976
2%b 19.31%
£976 £510
Note that the calculation includes the class interval, in this case
120% 18% 2 2%.
If we had chosen two discount rates further apart, such as 10 and 25 per cent, the
linear approximation would be less accurate:
at 10%, NPV £7,972
at 25%, NPV £3,860
IRR 10% a
£7,972
15%b 20.1%
£7,972 £3,860
Even over a range of 15 per cent the accuracy is to within 1 per cent of the true IRR.
In the Lara example, the NPV at various rates of interest is shown in Figure 5.1. The
graph shows a clearer relationship between IRR and NPV. We also have an idea of the
break-even rate of interest – or IRR – at around 19–20 per cent, as calculated earlier.
The IRR of 19.31 per cent is well above the required rate of 14 per cent and the project
is, therefore, wealth-creating.
Most managers have access to computer spreadsheets that solve the equation in a
fraction of a second and avoid tedious manual effort. However, our analysis explains
the logic behind the computer calculation.
For the Carling proposal, the IRR calculation is much more straightforward as the
annual cash flows are constant.
£17,000 PVIFA1r, 4 yrs2 £50,000
PVIFA1r, 4 yrs2 £50,000
2.9411
£17,000
Table 5.3
IRR calculations for
Lara proposal
Year
Cash flow (£)
PVIF at 18%
PV (£)
PVIF at 20%
PV (£)
0
1
2
3
4
NPV
(40,000)
16,000
16,000
16,000
12,000
1.0
0.84746
0.71818
0.60863
0.51579
(40,000)
13,559
11,490
9,738
6,189
976
1.0
0.83333
0.69444
0.57870
0.48225
(40,000)
13,333
11,111
9,259
5,787
(510)
IRR 18% a
976
2%b 19.31%
976 510
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Chapter 5 Investment appraisal methods
8
7
127
£7,972
6
5
£4,252 NPV at 14%
NPV (£000)
4
Figure 5.1
Lara proposal: NPV–IRR
graph
3
IRR 19.31%
2
1
0
–1
–2
–3
–4
–5
–6
5
10
15
Internal rate of return (%)
20
25
£(3,860)
Prince makes 500% profit on Canary Wharf
Prince Al Waleed Bin Talal Bin Abdul Aziz, the
Saudi prince said to be the richest businessman
outside the US, yesterday revealed that he had
realised 500 per cent profit by selling most of his
stake in Canary Wharf.
The Prince was one of a group of investors who
funded Canary Wharf chairman Paul Reichmann to
buy back the 85-acre estate in London’s docklands
from its bankers in 1995 for £800 million.
When Canary Wharf emerged from administration in 1993, it had attracted interest from
few potential tenants and most investors gave it
little chance of success.
On Tuesday the Prince completed the sale of
two-thirds of his stake, raising £122 million. The
Prince calculates that the internal rate of return,
over the five years of the investment, has been a
healthy 47.7 per cent per year. He will retain the
remaining third of his investment. ‘He likes it,’ a
spokesman said. Asked how the money will be
reinvested, a spokesman said, ‘Very wisely.’
Source: Based on Norma Cohen, Financial Times, 18 January 2001.
Referring to annuity tables (Appendix D), we find that for four years at 13 per cent,
the factor is 2.9745, and at 14 per cent it is 2.9137. The IRR is therefore between 13 and
14 per cent. This return falls just below the 14 per cent requirement, making it an
uneconomic proposal.
5.5
PROFITABILITY INDEX
Another method for evaluating capital projects is the profitability index (PI), sometimes called the benefit–cost ratio.
The profitability index
The profitability index is the ratio of the present value of project benefits to the present
value of initial costs. The decision rule is that projects with a PI greater than 1.0 are
acceptable.
Referring back to the present values calculated in Table 5.1, we can find for the Lara
proposal:
PI £44,252
PV benefits
1.1063
PV outlay
£40,000
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128 Part II Investment decisions and strategies
while for the Carling proposal:
PI £49,533
0.9906
£50,000
From this we see that the Lara is acceptable on financial grounds as the PI exceeds
1. The higher the PI, the more attractive the project. For independent projects, the PI
gives the same advice as NPV and IRR methods, although there are important reservations when projects are ‘mutually exclusive’ (see Section 5.8).
The PI can also be expressed as the net present value per £1 invested, i.e.
PI NPV
PV of outlays
If NPV per £1 invested exceeds zero, then the project should be accepted.
Self-assessment activity 5.2
What are the three main DCF methods and how do you know when to accept a capital
project with each?
(Answer in Appendix A at the back of the book)
5.6
PAYBACK PERIOD
payback period
Period of time a project’s annual net cash flows take to match
the initial cost outlay
discounted payback
Period of time the present value
of a project’s annual net cash
flows take to match the initial
cost outlay
Over the years, managers have come to rely upon a number of rule-of-thumb approaches to analyse investments. Two of the most popular methods are the payback period
and the accounting rate of return.
The payback period (PB) is the period of time taken for the future net cash inflows
to match the initial cash outlay.
Table 5.4 gives the cumulative cash flows for the two projects in our earlier example. After two years, the cumulative cash flow for Lara has reduced to $8,000; but by
the end of the third year it has improved to $8,000. The project therefore breaks even,
or pays back, in two and a half years. Similarly, the Carling pays back in 2.9 years.
Many companies set payback requirements for capital projects. For example, if all
projects are required to pay back within three years, both the Lara and Carling are
acceptable.
A number of modifications to simple payback are possible. Discounted payback
addresses the problem of comparing cashflows in different time periods. It calculates
Table 5.4
Payback period
calculation
Lara cash flow
Year
0
1
2
3
4
Cost
Cost savings
Cost savings
Cost savings
Cost savings
Payback: Lara 2 Carling 2 Carling cash flow
Annual
Cumulative
Annual
Cumulative
(40,000)
16,000
16,000
16,000
12,000
(40,000)
(24,000)
(8,000)
8,000
20,000
(50,000)
17,000
17,000
17,000
17,000
(50,000)
(33,000)
(16,000)
1,000
18,000
8,000
years 2.5 years
16,000
16,000
years 2.9 years
17,000
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Chapter 5 Investment appraisal methods
129
how quickly discounted cash flows recoup the initial investment. Referring back to the
NPV calculation for the Lara, the discounted payback period at 14 per cent interest is
approximately three and a half years (see below). The cumulative present values
recoup the initial outlay only in the final year.
Year
Present value @14%
Cumulative PV
(40,000)
14,035
12,312
10,800
(40,000)
(25,965)
(13,653)
(2,853)
Payback period 3.5 years
4,252
0
1
2
3
4
NPV
7,105
4,252
A fuller discussion of the popularity of the payback period will be given in Chapter 7.
However, we should note that this approach has some serious problems as a measure of
investment worth:
1 The time-value of money is ignored (except in the case of discounted payback).
2 Cash flows arising after the payback period are ignored.
3 The payback period criterion that firms stipulate for assessing projects has little theoretical basis. How do firms justify setting, say, a two-year payback requirement?
5.7
ACCOUNTING RATE OF RETURN
return on capital employed A key ratio in analysing accounts is the return on capital employed, or ROCE. This is
Operating profit expressed as a
percentage of capital employed
calculated as:
Profit before interest and tax
100
Capital employed
accounting rate of return
Return on investment over the
whole life of a project
This indicates a company’s efficiency in generating profits from its asset base. All
new investment should at least match existing assets in terms of its earning power.
However, the annual ROCE on a project will change each year. Typically, it is less profitable in the early years but improves over time as the project’s sales build up and as
the book value of the asset (i.e. cost less depreciation) declines.
The accounting rate of return (ARR) seeks to provide a measure of project profitability over the entire asset life. It compares the average profit of the project with the
book value of the asset acquired. The ARR can be calculated on the original capital
invested or on the average amount invested over the life of the asset.
Accounting rate of return
ARR 1total investment2 ARR 1average investment2 Average annual profit
Initial capital invested
100
Average annual profit
Average capital invested
100
Returning to our example, suppose the depreciation policy is to depreciate assets
over their useful lives on a straight-line basis. The annual depreciation for the Lara will
be £10,000 (i.e. £40,000 over four years) and for the Carling, £12,500. The annual profit from the proposals will be the annual cash saving less the annual depreciation. The
ARRs based on initial capital invested for the two proposals are shown in Table 5.5.
Alternatively, we could base the calculation of ARR on the average investment,
found by summing the opening and closing asset values and dividing by 2. This
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130 Part II Investment decisions and strategies
Table 5.5
Year
Calculation of the ARR
on total assets
Project
Lara
Cash flow (£)
Depreciation* (£)
Accounting
profit (£)
Carling
Cash flow (£)
Depreciation* (£)
Accounting
profit (£)
1
2
3
4
Average
16,000
(10,000)
6,000
16,000
(10,000)
6,000
16,000
(10,000)
6,000
12,000
(10,000)
2,000
–
–
5,000
17,000
(12,500)
4,500
17,000
(12,500)
4,500
17,000
(12,500)
4,500
17,000
(12,500)
4,500
–
–
4,500
ARR
5,000>40,000
1212 %
4,500>50,000
9%
*Straight-line depreciation is used in each case.
would yield answers for the Lara and Carling of 25 per cent and 18 per cent, respectively, double the returns based on the initial capital. (In our case, the residual values
are zero.)
A benefit of this profitability measure is that managers feel they understand it. It
makes sense to use an investment evaluation measure that is broadly consistent with
return on capital employed, which is the primary business ratio. However, the ARR
has some definite drawbacks. Suppose the Lara proposal is expected to continue into
Year 5, yielding a profit of £1,000 in that year. Common sense suggests that this would
make the proposal more attractive. However, the new ARR actually declines from 25
to 21 per cent as a result of averaging over five rather than four years.
ARR 1£6,000 £6,000 £6,000 £2,000 £1,0002>5
1£40,000 02>2
100 21%
It also takes no account of the size and life of the investment, or the timing of cash
flows. Moreover, this approach is based on profits rather than cash flows, the significance
of which we discuss in the next chapter. Such important weaknesses make ARR inappropriate as a main investment appraisal method, particularly when comparing projects.
Self-assessment activity 5.3
List four capital budgeting methods for evaluating project proposals. Identify the main
strengths and drawbacks of each.
(Answer in Appendix A at the back of the book)
5.8
RANKING MUTUALLY EXCLUSIVE PROJECTS
Suppose the manufacturers of the Lara also make the Bruno – a larger, more powerful,
but more erratic model – offering a further 50 per cent in cost savings each year, but
costing a further 50 per cent to purchase. The NPV will be 50 per cent greater than the
Lara, but the other measures of performance – based on ratios or percentages – will be
the same, as shown in Table 5.6.
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Table 5.6
Comparison of various
appraisal methods
Net present value (£)
Internal rate of return (%)
Profitability index
Payback period (years)
Accounting rate of return (%)
Lara
Bruno
Carling
4,252
19.3
1.1
2.5
25.0
6,378
19.3
1.1
2.5
25.0
(467)
13.5
0.99
2.9
18.0
In ranking mutually exclusive capital projects, we can reject the Carling for having a negative NPV and performance indicators that are consistently inferior to the
alternatives. While the Bruno and Lara are, pound-for-pound, identical, the Bruno creates £2,126 additional wealth and is preferred.
Under the conditions typically found in business, no single method is ideal, which
is why three or four different measures are often calculated. The ready availability of
spreadsheet packages with graphics facilities makes this a straightforward and inexpensive procedure. Investment appraisal techniques are tools to assist managers in
assessing the worth of a given project.
■
NPV or IRR?
In many cases, the choice of DCF method has no effect on the investment advice, and
it is simply a matter of personal preference. In certain circumstances, however, the
choice does matter. We shall consider three such situations:
1 Mutually exclusive projects.
2 Variable discount rates.
3 Unconventional cash flows.
■
Mutually exclusive projects
The decision to accept or reject a project cannot always be separated from other investment projects. For example, a company may have a spare plot of land that could be
used to build a warehouse or a sports centre. In such cases, the problem is to evaluate
mutually exclusive alternatives.
The earlier worked examples comparing the Lara, Carling and Bruno proposals are
mutually exclusive. Recall that, while the Lara and Bruno offered the same IRR, the latter offered a much higher NPV because it was on a larger scale. The weakness of IRR
is that it ignores the scale of the project. It implies that firms would prefer to make a
60 per cent IRR on an investment of £1,000 than a 30 per cent return on a £1 million
project. Clearly, project scale should be taken into consideration, which is why we recommend the NPV method when assessing mutually exclusive projects of different size
or duration.
■
Variable discount rates
It is common to discount cash flows at a constant rate of return throughout a project’s life.
But this may not always be appropriate. The required rate of return is linked to underlying interest rates and cash flow uncertainties, both of which can change over time.
This presents little difficulty in the case of NPV: different discount rates can be set
for each period. The IRR method, however, is compared against a single required rate
of return and cannot handle variable rates.
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132 Part II Investment decisions and strategies
■
Unconventional cash flows
There are three basic cash flow profiles:
Type
Cash flow pattern
Example
Conventional
Outlay followed by inflows
12
Inflow followed by outflow
12
More than one change of sign
12
Capital project
Reverse
Unconventional
Loan
Two-stage development project
For a reverse cash flow pattern, such as a loan where cash is received and interest
paid in subsequent periods, the IRR can be usefully applied. But in interpreting the
result, remember that the lower the rate of return the better, so the decision rule is to
accept the loan proposal if the IRR is below the required rate of return.
Unconventional cash flow patterns create particular difficulty for the IRR approach.
Consider the following project cash flows and NPV calculation at 10 per cent required
rate of return.
Initial outlay
Year
0
1
2
3
£
PVIF at 10%
PV (£ 000)
100,000
360,000
432,000
173,000
NPV
1.00
0.909
0.826
0.751
100
327
357
130
0
With an NPV of zero, the IRR is, by definition, 10 per cent. But at certain other rates,
such as 20 per cent and 30 per cent, the NPV is still zero!
Multiple solutions may occur where there are multiple changes of sign. In our
example there are three changes in sign – from negative cash flow at the start to positive in Year 1, negative in Year 2 and positive in Year 3. While a conventional project
has only one IRR, unconventional projects may have as many IRRs as there are
changes in the cash flow sign.
Self-assessment activity 5.4
Why do problems arise in evaluating mutually exclusive projects? What approach would
you recommend in such circumstances?
(Answer in Appendix A at the back of the book)
To summarise, the use of NPV and IRR is a matter of personal preference in most
instances. But where the evaluation is for mutually exclusive projects, where the discount rate is not constant throughout the project’s life, or where an unconventional
cash flow pattern is suspected, we recommend use of the net present value approach.
To underline the superiority of NPV we need to examine the respective reinvestment
assumptions of the two methods.
The NPV method assumes that all cash flows can be reinvested at the firm’s cost of
capital. This is entirely sensible, since the discount rate is an opportunity cost of capital that should reflect the alternative use of funds. The IRR method assumes that a project’s annual cash flows can be reinvested at the project’s internal rate of return. Thus,
a project offering a 30 per cent IRR, given a 12 per cent cost of capital, assumes that
interim cash flows are compounded forward at the project’s rate of return (30 per cent)
rather than at the cost of capital (12 per cent). In effect, therefore, the IRR method
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Chapter 5 Investment appraisal methods
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Table 5.7
Cash flows (£)
Comparison of mutually
exclusive projects
Proposal
Year 0
18,896
18,896
X
Y
Year 1 Year 2
Year 3 Year 4
8,000
0
8,000
8,000
8,000
4,000
8,000
26,164
Undiscounted
cash flow
IRR
13,104
19,268
NPV
at 10%
25%
22%
6,463
8,290
includes a bonus of the assumed benefits accruing from the reinvestment of interim
cash flows at rates of interest in excess of the cost of capital. This is a serious error for
projects with IRRs well above the cost of capital.
Consider the mutually exclusive investment proposals given in Table 5.7. X and Y
each cost £18,896. Project rankings reveal that X has the higher internal rate of return
but the lower net present value. Figure 5.2 shows how this apparent anomaly occurs.
(Strictly speaking, the graphs should be curvilinear.)
While Project Y has the higher NPV when discounted at 10 per cent, it has the lower
IRR, the two projects intersecting in the graph at around 17 per cent. Wherever there
is a sizeable difference between the project IRR and the discount rate, this problem
becomes a distinct possibility.
Harry Potter and the global sales hopes of Coca-Cola
When the long-awaited Harry Potter movie
opened one of the biggest stars was not even
seen on film. As millions enjoy Harry Potter and
the Philosopher’s Stone, Coca-Cola is assuming
the role of exclusive marketing partner.
Never has so much been poured into one
movie by one company. Since lengthy negotiations
with Warner Bros Pictures for exclusivity last year,
the beverage group has sunk $150 million into a
global marketing programmes usually preserved
for world sporting events such as the Olympics.
In many ways, Harry Potter is able to do what
Coca-Cola has been attempting for many years –
to reach out to a younger audience while not
alienating adults. That is crucial as Coca-Cola reinvents itself as an all-beverage company, offering
from fun juice drinks to gourmet coffees. But Harry
Potter also serves another purpose: instantly elevating the Coke brand by its sheer popularity worldwide, something its own advertising campaigns
have failed to do. Such a powerful platform seems
to justify spending nearly 10 per cent of the
group’s global marketing budget on Harry Potter.
The biggest critics Coke has to worry about
are its shareholders. Its share price has been relatively flat since the announcement of the Harry
Potter campaign. ‘Investors are simply looking for
Coke to meet volume goals. That would be
enough,’ says Ms Levy, a spokesperson for the
firm. ‘If this can help re-establish the brand in the
hearts of consumers, then putting 10 per cent of
the budget into Harry Potter won’t be a bad
investment.’
Source: Based on Financial Times, November 15 2001.
NPV (£)
20,000
15,000
Project Y
8,290
10,000
5,000
0
Figure 5.2
NPV and IRR compared
Intersection point (17%)
Project X
6,463
5
10
15
Rate of interest (%)
20
25
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134 Part II Investment decisions and strategies
Self-assessment activity 5.5
Take another look at the graphs in Figure 5.2. How would you explain to a manager that
Project X, with the higher IRR, is actually less attractive than Project Y?
(Answer in Appendix A at the back of the book)
5.9
INVESTMENT EVALUATION AND CAPITAL RATIONING
We have seen that, under the somewhat limiting assumptions specified, the wealth of a
firm’s shareholders is maximised if the firm accepts all investment proposals that have
positive net present values. Alternatively, the NPV decision rule may be restated as:
accept investments that offer rates of return in excess of their opportunity costs of capital. The opportunity cost of capital is the return shareholders could obtain for the same
level of risk by investing their capital elsewhere. Implicit in the NPV decision rule is the
notion that capital is always available at some cost to finance investment opportunities.
In this section, we relax another assumption of perfect capital markets to include the
situation where firms are restricted from undertaking all the investments offering positive net present values. Although individual projects cannot be accepted/rejected on the
basis of the NPV rule, the essential problem remains: namely, to determine the package
of investment projects that offers the highest total net present value to the shareholders.
■
The nature of constraints on investment
capital rationing
The process of allocating capital
to projects where there is insufficient capital to fund all valuecreating proposals
■
In imperfect markets, the capital budgeting problem may involve the allocation of
scarce resources among competing, economically desirable projects, not all of which
can be undertaken. This capital rationing applies equally to non-capital, as well as capital, constraints. For example, the resource constraint may be the availability of skilled
labour, management time or working capital requirements. Investment constraints may
even arise from the insistence that top management appraise and approve all capital
projects, thus creating a backlog of investment proposals.
Hard and soft rationing
Capital rationing may arise either because a firm cannot obtain funds at market rates of
return, or because of internally imposed financial constraints by management.
Externally imposed constraints are referred to as hard rationing and internally imposed
constraints as soft rationing.
The Wilson Committee (1980) found no evidence of any general shortage of finance
for industry at prevailing rates of interest and levels of demand. A survey of managers
(Pike 1983) found that:
1 The problem of low investment essentially derives not from a shortage of finance
but from an inadequate demand for funds.
2 Capital constraints, where they exist, tend to be internally imposed rather than
externally imposed by the capital market.
3 Capital constraints are more acutely experienced by smaller, less profitable and
higher-risk firms.
■
Soft rationing
Why should the internal management of a company wish to impose a capital expenditure constraint that may actually result in the sacrifice of wealth-creating projects? Soft
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Chapter 5 Investment appraisal methods
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rationing may arise because of the following:
1 Management sets maximum limits on borrowing and is unable or unwilling to raise
additional equity capital in the short term. Investment is restricted to internally generated funds.
2 Management pursues a policy of stable growth rather than a fluctuating growth
pattern with its attendant problems.
3 Management imposes divisional ceilings by way of annual capital budgets.
4 Management is highly risk-averse and operates a rationing process to select only
highly profitable projects, hoping to reduce the number of project failures.
The capital budget forms an essential element of the company’s complex planning
and control process. It may sometimes be expedient for capital expenditure to be
restricted – in the short term – to permit the proper planning and control of the organisation. Divisional investment ceilings also provide a simple, if somewhat crude,
method of dealing with biased cash flow forecasts. Where, for example, a division is
in the habit of creating numbers to justify the projects it wishes to implement, the institution of capital budget ceilings forces divisional management to set its own priorities
and to select those offering highest returns.
It is clear that capital rationing can be explained, in part, by imperfections in both
the capital and labour markets and agency costs arising from the separation of ownership from management. Of particular relevance are the problems of information
asymmetry and transaction costs.
Information asymmetry
Shareholders and other investors in a business do not possess all the information available
to management. Nor do they always have the necessary expertise to appreciate fully the
information they do receive. Capital rationing may arise because senior managers, convinced that their set of investment proposals is wealth-creating, cannot convince a more
sceptical group of potential investors who have far less information on which to make an
assessment and who may be influenced by the company’s recent performance record.
Transaction costs
The issuing and other costs associated with raising long-term capital do not vary in
direct proportion to the amount raised. Corporate treasurers in large organisations will
not want to go to the capital market each year for relatively small sums of money if the
costs can be significantly reduced by raising much larger sums at less frequent intervals.
Capital rationing is therefore a distinct possibility in the intervening years, although this
usually means delaying the start date for investments rather than outright rejection.
■
One-period capital rationing in Mervtech plc
The simplest form of capital rationing arises when financial limits are imposed for a single period. For that period of time, the amount of funds available becomes the limiting
factor. The manufacturing division of Mervtech plc has been set an upper limit on capital spending for the coming year of £20 million. It is not normal practice for the group
to set investment ceilings, and it is anticipated that the capital constraint will not extend
into future years. Assuming a cost of capital of 10 per cent, which of the investment
opportunities set out in Table 5.8 should divisional management select?
In the absence of any financial constraint, projects A–D, each with positive net present values, would be selected. Once this information has been communicated to
investors, the total stock market value would, in theory at least, increase by £44 million – the sum of their net present values.
However, a financial constraint may prevent the selection of all profitable projects.
If so, it becomes necessary to select the investment package that offers the highest net
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136 Part II Investment decisions and strategies
Table 5.8
Investment opportunities for Mervtech plc
Cash flows (£m)
Project
A
B
C
D
E
Initial
cost (£m)
Year 1
15
5
12
8
20
17
5
12
12
10
Year 2
Present
value
at 10% (£m)
NPV
at
10% (£m)
17
10
12
11
10
30
13
21
20
17
15
8
9
12
3
present value within the £20 million expenditure limit. A simple method of selecting
projects under these circumstances is the profitability index. Recall that this measure
is defined as:
Profitability index Present value
Investment outlay
Project selection is made on the basis of the highest ratio of present value to investment outlay. This method is valuable under conditions of capital rationing because it
focuses attention on the net present value of each project relative to the scarce resource
required to undertake it. Appraising projects according to the NPV per £1 of investment outlay can give different rankings from those obtained from application of the
NPV rule. For example, while in the absence of capital rationing, project A ranks highest (using the NPV rule), project B ranks highest when funds are limited, as shown in
Table 5.9. Assuming project independence and infinite divisibility, divisional management will obtain the maximum net present value from its £20 million investment
expenditure permitted by accepting projects B and D in total and £7 million or 7/15 of
project A.
However, the profitability index rarely offers optimal solutions in practice. First,
few investment projects possess the attribute of divisibility. Where it is possible for
projects to be scaled down to meet expenditure limits, this is frequently at the expense
of profitability. Let us suppose that projects are not capable of division. How would
this affect the selection problem? The best combination of projects now becomes A and
B, giving a total net present value of £23 million. Project D, which ranked above A
using the profitability index, is now excluded. Even more fundamental than this, however, is the limitation that the profitability index is appropriate only when capital
rationing is restricted to a single period. This is not usually the case. Firms experiencing either hard or soft capital rationing tend to experience it over a number of periods.
In summary, the profitability index provides a convenient method of selecting projects under conditions of capital rationing when investment projects are divisible and
independent, and when only one period is subject to a resource constraint. Where,
as is more commonly the case, these assumptions do not hold, investment selections should be made after examining the total net present values of all the feasible
Table 5.9
NPV vs. PI for Mervtech
plc
Project
B
D
A
C
E
Profitability index
Outlay (£m)
Outlay (£m)
NPV (£m)
2.6
2.5
2.0
1.7
0.8
5 accept
8 accept
15 accept 7/15
12 reject
20 reject
60
5
8
7
–
–
38
8
12
7
–
–
27
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Chapter 5 Investment appraisal methods
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alternative combinations of investment opportunities falling within the capital outlay
constraints.
Self-assessment activity 5.6
What do you understand by ‘soft’ and ‘hard’ forms of capital rationing? Give two
approaches available to resolve capital rationing problems.
(Answer in Appendix A at the back of the book)
■
Multi-period capital rationing
Many business problems have similar characteristics to those exhibited in the capital
rationing problem, namely:
1 Scarce resources have to be allocated between competing alternatives.
2 An overriding objective that the decision-maker is seeking to attain.
3 Constraints, in one form or another, imposed on the decision-maker.
As the number of alternatives and constraints increases, so the decision-making
process becomes more complex. In such cases, mathematical programming models are
particularly valuable in the evaluation of decision alternatives, for two reasons:
1 They provide descriptive representations of real problems using mathematical
equations. Because they capture the critical elements and relationships existing in
the real system, they provide insights about a problem without having to experiment directly on the actual system.
2 They provide optimal solutions – that is, the best solution for a given problem
representation.
A mathematical programming approach to solving more complex capital rationing
problems is provided in Appendix II to this chapter.
SUMMARY
We have examined a number of commonly employed investment appraisal techniques
and asked the question: to what extent do they assist managers in making wealthcreating decisions? The primary methods advocated involve discounting the incremental cash flows resulting from the investment decision, although non-discounting
techniques are useful secondary methods for evaluating capital projects.
Key points
■
The net present value (NPV) method discounts project cash flows at the firm’s
required return and then sums the cash flows. The decision rule is: accept all projects whose NPV is positive.
■
The internal rate of return (IRR) is that discount rate which, when applied to project cash flows, produces a zero NPV. Projects with IRRs above the required return
are acceptable.
■
The profitability index (PI) is the ratio of the present value of project benefits to the
present value of investment costs. The decision rule is to accept projects with a PI
greater than 1.
Continued
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138 Part II Investment decisions and strategies
■
The NPV, IRR and PI methods give the same investment advice for independent
projects. But where projects are mutually exclusive, differences can arise in rankings.
■
The NPV approach is viewed as more sound than the IRR method because it
assumes reinvestment at the required return rather than the project’s IRR.
■
The modified IRR (MIRR) is that rate of return which, when the initial outlay is
compared with the terminal value of the project’s cash flows reinvested at the cost
of capital, gives an NPV of zero. This method provides a rate of return consistent
with the NPV approach. This is discussed in Appendix I.
■
Payback is a useful method, but ignores cash flows beyond the payback period.
Simple payback also ignores the time-value of money.
■
Accounting rate of return (ARR) compares the average profit of the project against
the book value of the asset acquired. Its main merit is that, as a measure of profitability, it can be related to the accounts of the business. However, it takes no
account of the timing of cash flows or of the size and life of the investment.
■
Capital rationing, where it exists, tends to be of the ‘softer’ form where management voluntarily imposes investment ceilings in the short term.
■
Single-period capital rationing is resolved by ranking projects according to their
profitability index. More complex multi-period capital rationing problems demand
a mathematical programming approach.
Further reading
Most good finance texts cover the topic of investment appraisal well, including Brealey, Myers and
Allen (2005). These texts also address the capital rationing problem. More detailed treatment of
capital rationing is found in Pike (1983), Elton (1970), Lorie and Savage (1955) and Weingartner
(1977). For a fuller discussion on the modified IRR, see McDaniel et al. (1988).
APPENDIX I
MODIFIED IRR
Most managers prefer the IRR to the NPV method. The modified IRR seeks to adjust
the IRR so that it has the same reinvestment assumption as the NPV approach.
■
The modified internal rate of return (MIRR)
MIRR is that rate of return which, when the initial outlay is compared with the terminal value of the project’s net cash flows reinvested at the cost of capital, gives an NPV
of zero.
This involves a two-stage process:
1 Calculate the terminal value of the project by compounding forward all interim
cash flows at the cost of capital to the end of the project.
2 Find the rate of interest that equates the terminal value with the initial cost.
We established earlier that the Lara proposal offered an NPV of £4,252 (Table 5.1)
and an IRR of approximately 19 per cent (Table 5.3). Table 5.10 shows that by compounding the interim cash flows at 14 per cent to the end of Year 4, the project offers
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Chapter 5 Investment appraisal methods
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a terminal value of £74,738. To find the Year 4 present value factor that comes closest to equating the terminal value with the initial outlay, we divide the initial outlay by the terminal value and look up the interest rate that gives this factor in Year
4 (see Appendix B). For the Lara project, the MIRR is approximately 17 per cent, a
good 2 per cent below the IRR figure. For more profitable projects, the deviation
would be greater.
Table 5.10
Year
Cash flow (£)
(a) Find the terminal value
1
16,000
2
16,000
3
16,000
4
12,000
Modified IRR for Lara
Future value factor @ 14%
Terminal value (£)
11.142 3
11.142 2
1.14
1.00
23,704
20,794
18,240
12,000
74,738
(b) Find the rate of interest (denoted by x) which equates the terminal value with
initial cost:
PVIF1x%, 4yrs2 £40,000>£74,738 0.535
Using tables (Appendix C) for four years we find that 17 per cent gives a PVIF of 0.534.
£
To check: £74,738 0.534 39,910
less initial investment
(40,000)
NPV
(90) i.e. close to zero
The modified IRR is approximately 17 per cent compared with the IRR of 19.3 per cent.
You might like to check this out using an Excel spreadsheet. In cells A1 to A5 type
in -40,000, 16,000, 16,000, 16,000, 12,000. In cell A6 click on the fx icon and select
Financial/MIRR. In the box enter for Values, A1:A5, and .14 for both Finance rate and
Reinvestment rate.
Self-assessment Activity 5.7
Describe how the modified IRR is calculated. What advantages does the MIRR have over
the IRR in assessing capital investment decisions?
(Answer in Appendix A at the back of the book)
APPENDIX II
MULTI-PERIOD CAPITAL RATIONING AND MATHEMATICAL
PROGRAMMING
Where an overriding financial objective exists (such as maximising shareholder
wealth) and financial constraints are expected to operate over a number of years, the
allocation of capital resources to investment projects is best solved by the mathematical programming approach.
Many programming techniques have been developed. We shall concentrate on
the most common technique: linear programming. The assumptions and limitations
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140 Part II Investment decisions and strategies
underlying the LP approach will be discussed in a subsequent section. Problemsolving using the LP approach involves four basic steps:
1 Formulate the problem. This requires specification of the objective function, input
parameters, decision variables and all relevant constraints. Take a firm that produces two products, A and B, with contributions per unit of £5 and £10 respectively. The firm wishes to determine the product mix that will maximise its total
contribution. The objective function may be expressed as follows:
maximise contribution: £5A + £10B
A and B are the decision variables representing the number of units of products A
and B that should be produced. The input values £5 and £10 specify the unit contribution values for products A and B respectively. Constraint equations may also
be determined to describe any limitations on resources, whether imposed by managerial policies or the external environment.
2 Solve the LP problem. Simple problems can be solved using either a graphical
approach or the simplex method. More complex problems require a computerbased solution algorithm.
3 Interpret the optimal solution. Examine the effect on the total value of the objective
function if a binding constraint were marginally slackened or tightened.
4 Conduct sensitivity analysis. Assess, for each input parameter, the range of values for
which the optimal solution remains valid.
These four stages in the LP process are illustrated in the following example.
Example: multi-period capital rationing in Flintoff plc
Flintoff’s five-year planning exercise shows that the cost of its six major projects, forming
the basis of the firm’s investment programme, exceeds the planned finance available.
Flintoff is already highly geared and control is in the hands of a few shareholders who are
reluctant to introduce more equity funds. Accordingly, the main source of funds is
through cash generated from existing operations, estimated to be £300,000 p.a. over the
next five years. The six projects are independent and cannot be delayed or brought forward. Each project has a similar risk complexion to that of the existing business. If necessary, projects are capable of division but no more than one of each is required. The
planned investment schedule and associated cash flows are given in Table 5.11.
The six projects, if implemented, are forecast to produce a total NPV of £857,000.
However, the annual capital constraint of £300,000 means that for the next three years
the required investment expenditure exceeds available investment finance, i.e. there is
a capital rationing problem.
The solution sequence is as follows.
■
1. Specify the problem
The objective function seeks to maximise the NPV from the given set of projects available.
Max NPV: 130A 184B 35C 42D 186E 280F
Table 5.11
Flintoff plc: planned
investment schedule
(£000)
Project outlays
Year
A
B
0
–
200
1
220
220
2
66
3
NPV
130
184
Total NPV = £857,000
C
D
E
F
220
100
50
110
150
24
48
–
–
500
35
42
200
186
280
Total
outlay
Available
capital
554
718
616
200
300
300
300
300
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Chapter 5 Investment appraisal methods
However, given the capital expenditure constraints over the coming years, we must
express for each year the capital required for each project and the maximum capital
available each year (i.e. £ 300,000):
Year 0
Year 1
Year 2
Year 3
200A 220C 110D 24E 300
220A 220B 100C 150D 48E 300
66B 50C 500F 300
200E 300
In addition to the capital constraints, we need to define the bounds for each variable. As no more than one of each project is required and projects are divisible, we can
specify the bounds as:
A, B, C, D, E, F 0 1
This linear programming formulation tells us to find the mix of projects producing
the highest total net present value, given the constraint that only £300,000 can be spent
in any year and that not more than one of each project is permitted.
■
2. Solve the problem
Using a linear program on the computer gives the solution in Table 5.12. Flintoff plc
should accept investment proposals B and E in full plus 14.5 per cent of project A and
46.8 per cent of project F. This will produce the highest possible total net present value
available, £520,000. This is significantly less than the £857,000 total NPV if no constraints are imposed.
■
3. Interpret the optimal solution
Table 5.12 shows that only in Years 1 and 2 is the full £300,000 utilised. These years
then impose binding constraints – their existence limits the company’s freedom to pursue its objective of NPV maximisation because it restricts the investment finance available to the firm in those years. Conversely, Years 0 and 3 are non-binding: they do not
constrain the firm in its efforts to achieve its objective. Hence while there is no additional opportunity cost (besides that already incorporated in the discount rate), for
non-binding periods there is an additional opportunity cost attached to the use of
investment finance in the two years where constraints are binding. These additional
opportunity costs are termed shadow prices (or dual values). Shadow prices show
how much the decision-maker would be willing to pay to acquire one additional unit
Table 5.12
Capital outlay (£ 000)
Projects accepted
based on LP solution
Project
A
B
C
D
E
F
Proportion
accepted
NPV
(£ 000)
0.145
1
0
0
1
0.468
19
184
–
–
186
131
520
Year 0
Year 1
Year 2
29
32
220
–
66
29
–
58
48
–
300
–
234
300
Year 3
–
200
–
200
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142 Part II Investment decisions and strategies
of each constrained resource. In this case, computer analysis reveals that the shadow
prices are:
Year
0
1
2
3
Shadow price (£)
0
0.59
0.56
0
Constraint
non-binding
binding
binding
non-binding
A £1 increase (reduction) in capital spending in Year 1 would produce an increase
(reduction) in total NPV of £0.59. Similarly, for Year 2 a £1 change in investment
expenditure would result in a £0.56 change in total NPV. Because the capital constraints in Years 0 and 3 are non-binding, their shadow prices are zero and a marginal
change in capital spending in those years will have no impact on the NPV objective
function. Shadow prices, while of value in indicating the additional opportunity cost,
can be used only within a specific range. In addition, it is desirable to ascertain the
effect of changes in input parameters on the optimal solution. These issues require
some form of sensitivity analysis.
■
4. Perform sensitivity analysis
The computer output provides two additional pieces of information. First, it tells the
decision-maker the maximum variation for each binding constraint. In our example,
the shadow price for the Year 1 constraint has a range of 36 to 188. In other words,
the shadow price of £0.59 would hold up to an increase in capital expenditure for that
year of £188,000, or a reduction of £36,000.
The program also indicates the margin of error permitted for input parameters
before the optimal solution differs. In our example, the actual NPV for the optimal
investment mix could fall as indicated below and still not change the optimal solution:
Project
Maximum permitted
fall in NPV (£000)
68
17
158
280
A
B
E
F
This facility is particularly appropriate as a means of assessing the margin of error
permitted for risky projects under conditions of capital rationing.
LP assumptions
In order to assess the value of the basic linear programming approach, we must consider the assumptions underlying its application. These are as follows:
1
2
3
4
5
All input parameters to the LP model are certain.
There is a single objective to be optimised.
The objective function and all constraint equations are linear.
Decision variables are continuous (i.e. divisible).
There is independence among decision variables and resources available.
Most, if not all, of these limiting assumptions can be relaxed by using more complex
mathematical programming. For example, uncertainty, multiple objectives and nonlinearity can be better addressed by other approaches such as stochastic LP, goal programming and quadratic programming respectively.
For most businesses, the LP assumption that projects are divisible is unrealistic.
Even if a project could be operated on a reduced scale, it is unlikely that the NPV
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Chapter 5 Investment appraisal methods
143
would reduce pro rata because many of the fixed costs would remain while the benefits of sale would be reduced. Integer programming is more appropriate when projects
are non-divisible. This is a special case of linear programming where variables can
take only the values 0 (reject the project) or 1 (accept it in toto).
Applying integer programming to Flintoff plc requires only one change in the problem specification. The bounds become:
A, B, C, D, E, F, 0 or 1
The solution, provided by an integer programming computer application, shows
that only two projects should be accepted: projects B and E. These offer a combined
NPV of £370,000, which is the best available given the capital constraints. This is well
under half the £857,000 total NPV achievable in the absence of capital rationing (see
Table 5.11). Were the shareholders of Flintoff plc aware of these lost wealth-creating
opportunities, they might well be concerned and ask the chairman whether the capital constraints were really as fixed as they appeared to be!
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144 Part II Investment decisions and strategies
QUESTIONS
Questions with a coloured number have solutions in Appendix B on page 694.
1 Microtic Ltd, a manufacturer of watches, is considering the selection of one from two mutually exclusive
investment projects, each with an estimated five-year life. Project A costs £1,616,000 and is forecast to generate annual cash flows of £500,000. Its estimated residual value after five years is £301,000. Project B, costing
£556,000 and with a scrap value of £56,000, should generate annual cash flows of £200,000. The company operates a straight-line depreciation policy and discounts cash flows at 15 per cent p.a.
Microtic Ltd uses four investment appraisal techniques: payback period, net present value, internal rate of
return and accounting rate of return (i.e. average accounting profit to initial book value of investment).
Make the appropriate calculations and give reasons for your investment advice.
2 Mace Ltd is planning its capital budget for 19_7 and 19_8. The company’s directors have reduced their initial
list of projects to five, the expected cash flows of which are set out below:
Project
1
2
3
4
5
19_7
19_8
19_9
19_0
NPV
60,000
30,000
40,000
0
50,000
30,000
20,000
50,000
80,000
10,000
25,000
25,000
60,000
45,000
30,000
25,000
45,000
70,000
55,000
40,000
1,600
1,300
8,300
900
7,900
None of the five projects can be delayed and all are divisible. Cash flows arise on the first day of the year.
The minimum return required by shareholders of Mace Ltd is 10 per cent p.a. Which projects should Mace Ltd
accept if the capital available for investment is limited to £100,000 on 1 January 19_7, but readily available at
10 per cent p.a. on 1 January 19_8 and subsequently?
3 The directors of Mylo Ltd are currently considering two mutually exclusive investment projects. Both projects
are concerned with the purchase of new plant. The following data are available for each project:
Project
Cost (immediate outlay)
Expected annual net profit (loss)
Year 1
2
3
Estimated residual value
1 (£)
2 (£)
100,000
60,000
29,000
(1,000)
2,000
7,000
18,000
(2,000)
4,000
6,000
The company has an estimated cost of capital of 10 per cent and employs the straight-line method of depreciation for all fixed assets when calculating net profit. Neither project would increase the working capital of
the company. The company has sufficient funds to meet all capital expenditure requirements.
Required
(a) Calculate for each project:
(i) the net present value
(ii) the approximate internal rate of return
(iii) the profitability index
(iv) the payback period
(b) State which, if any, of the two investment projects the directors of Mylo Ltd should accept, and why.
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Chapter 5 Investment appraisal methods
(c) State, in general terms, which method of investment appraisal you consider to be most appropriate for
evaluating investment projects and why.
(Certified Diploma)
4 Mr Cowdrey runs a manufacturing business. He is considering whether to accept one of two mutually exclusive investment projects and, if so, which one to accept. Each project involves an immediate cash outlay of
£100,000. Mr Cowdrey estimates that the net cash inflows from each project will be as follows:
Net cash inflow
at end of:
Year 1
Year 2
Year 3
Project A
(£)
Project B
(£)
60,000
40,000
30,000
10,000
20,000
110,000
Mr Cowdrey does not expect capital or any other resource to be in short supply during the next three years.
Required
(a) Prepare a graph to show the functional relationship between net present value and the discount rate for
the two projects (label the vertical axis ‘net present value’ and the horizontal axis ‘discount rate’).
(b) Use the graph to estimate the internal rate of return of each project.
(c) On the basis of the information given, advise Mr Cowdrey which project to accept if his cost of capital is
(i) 6 per cent; (ii) 12 per cent.
(d) Describe briefly any additional information you think would be useful to Mr Cowdrey in choosing
between the two projects.
(e) Discuss the relative merits of net present value and internal rate of return as methods of investment
appraisal.
Ignore taxation.
(ICAEW)
5 The directors of XYZ plc wish to expand the company’s operations. However, they are not prepared to borrow at the present time to finance capital investment. The directors have therefore decided to use the company’s cash resources for the expansion programme.
Three possible investment opportunities have been identified. Only £400,000 is available in cash and the
directors intend to limit the capital expenditure over the next 12 months to this amount. The projects are not
divisible (i.e. cannot be scaled down) and none of them can be postponed. The following cash flows do not
allow for inflation, which is expected to be 10 per cent per annum constant for the foreseeable future.
Expected net cash flows (including residual values)
Project
A
B
C
Initial investment
£
Year 1
£
Year 2
£
Year 3
£
350,000
105,000
35,000
95,000
45,000
40,000
110,000
45,000
25,000
200,000
45,000
125,000
The company’s shareholders currently require a return of 15 per cent nominal on their investment.
Ignore taxation.
Required
(a) (i) Calculate the expected net present value and profitability indexes of the three projects; and
(ii) comment on which project(s) should be chosen for the investment, assuming the company can invest
surplus cash in the money market at 10 per cent. (Note: you should assume that the decision not to
borrow, thereby limiting investment expenditure, is in the best interests of its shareholders.)
(b) Discuss whether the company’s decision not to borrow, thereby limiting investment expenditure, is in the
best interests of its shareholders.
(CIMA)
145
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146 Part II Investment decisions and strategies
6 Raiders Ltd is a private limited company financed entirely by ordinary shares. Its effective cost of capital, net
of tax, is 10 per cent p.a. The directors are considering the company’s capital investment programme for the
next two years, and have reduced their initial list of projects to four. Details of the projects’ cash flows (net of
tax) are as follows (in £000):
Project
A
B
C
D
Immediately
After 1
year
After 2
years
After 3
years
NPV
(at 10%)
IRR
(to nearest 1%)
400
300
300
0
50
200
150
300
300
400
150
250
350
400
150
300
157.0
150.0
73.5
159.5
26%
25%
23%
50%
None of the projects can be delayed. All projects are divisible; outlays may be reduced by any proportion and
net inflows will then be reduced in the same proportion. No project can be undertaken more than once. Raiders
Ltd is able to invest surplus funds in a bank deposit account yielding a return of 7 per cent p.a., net of tax.
Required
(a) Prepare calculations showing which projects Raiders Ltd should undertake if capital for immediate
investment is limited to £500,000, but is expected to be available without limit at a cost of 10 per cent p.a.
thereafter.
(b) Provide a mathematical programming formulation to assist the directors of Raiders Ltd in choosing
investment projects if capital available immediately is limited to £500,000, capital available after one year
is limited to £300,000, and capital is available thereafter without limit at a cost of 10 per cent p.a.
(c) Outline the limitations of the formulation you have provided in (b).
(d) Comment briefly on the view that in practice capital is rarely limited absolutely, provided that the borrower is willing to pay a sufficiently high price, and in consequence a technique for selecting investment
projects that assumes that capital is limited absolutely is of no use.
(ICAEW)
Practical assignment
Either drawing on your own experience, or by asking someone you know in management, find out the primary
investment appraisal techniques employed in an organisation. How well does the appraisal system appear to
operate?
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6
Project appraisal – applications
To boldly go into space-age investment
There is a danger that investment analysis can
become bogged down in unnecessary detail. So how
does an entrepreneur like Sir Richard Branson, inventor of the Virgin brand, make investment decisions?
Like many other top managers, Branson places
more reliance on experience and ‘hunch’ in decision-making than detailed financial analyses.
However, he also works through the risks involved
and whether they can be managed. In his autobiography, Branson claims to make up his mind about
whether a business proposal excites him within
about thirty seconds of looking at it. He relies more
on gut instinct than researching huge quantities of
statistics. The idea of operating a Virgin airline
grabbed his imagination, but he had to work out
in his own mind what the potential risks were
(Branson, 1998, p. 216).
In 2004 Branson took a giant step in announcing
that he would boldly go into the space age through
his new company – Virgin Galactic – the world’s first
commercial space business. A fleet of five Virgin
spacecraft will carry 3,000 passengers into space
between 2007 and 2012. The company expects to
spend $100 million over five years to develop the
spacecraft and the first Virgin astronauts will have to
pay £105,000 for a flight.
Branson also argues that fun is at the core of the
way he likes to do business and the main secret of
Virgin’s success. He observes that the idea of business
being fun and creative goes right against the grain of
convention, and it’s certainly not how they teach it at
some of those business schools, where, as he puts it,
‘business means hard grind and lots of discounted cash
flows and net present values!’ (Branson, 1998, p. 490).
Learning objectives
Having read this chapter, you should be well equipped to handle most capital investment decision
problems found either on examination papers or in business. Skills should develop in the following
areas:
■
Identifying the relevant information in investment analysis.
■
Evaluating replacement and other investment decisions.
■
Handling inflation.
■
Assessing the effects of taxation on investment decisions.
■
Investment appraisal practices, strengths and limitations.
■
Identifying the appropriate discount rate.
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148 Part II Investment decisions and strategies
6.1
INTRODUCTION
In the previous chapter, we examined a variety of approaches to assessing investment
projects. The focus was almost exclusively on the appropriate appraisal method. But
even the best appraisal method is of little use unless we can first identify the relevant
information.
Investment decisions, particularly larger ones with strategic implications, are not
usually made on ‘the spur of the moment’. The whole process, from the initial idea
through to project authorisation, usually takes many months, or even years. A vital
part of this process is gathering information to identify the incremental cash flows pertaining to the investment decision. In this chapter, we consider the principles underlying economic feasibility analysis and apply them to particular situations. We pay
particular attention to the treatment of inflation and taxation in project evaluation.
■
Need for relevant information
In financial management, as with all areas of management, an effective manager needs
to identify the right information for decision-making. In the case of capital investment
decisions, committing a substantial proportion of the firm’s funds to non-routine, largely irreversible actions can be risky and demands a careful examination of all the relevant information available.
Information on the likely costs and benefits of an investment proposal, its expected
economic life, appropriate inflation rates and discount rates should be gathered to provide a clearer picture of the project’s economic feasibility. Frequently, we find that the
reliability of the information source varies. For example, a demand forecast from a marketing executive with a track record of making wildly inaccurate forecasts will be
viewed differently from an official quote for the cost of a machine. The accounting system and formal reports provide a part of the relevant information, the remainder coming through informal channels, frequently more qualitative than quantitative in nature.
In identifying and analysing information, managers should remember that effective information should, wherever possible, be relevant, reliable, timely, accurate and
cost-efficient.
6.2
INCREMENTAL CASH FLOW ANALYSIS
We stressed in the previous chapter that the financial input into any investment decision analysis should be based on the incremental cash flows arising as a consequence
of the decision. These can be found by calculating the differences between the forecast
cash flows from going ahead with the project and the forecast cash flows from not
accepting the project.
This is not always easy. To illustrate this point, we consider how investment analysis handles opportunity costs, sunk costs, associated cash flows, working capital
changes, interest costs and fixed overheads.
Self-assessment activity 6.1
What do you understand by the term ‘incremental cash flow’?
(Answer in Appendix A at the back of the book)
■
Remember opportunity costs
Capital projects frequently give rise to opportunity costs. For example, a company has
developed a patent to produce a new type of lawnmower. If it makes the product, the
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149
expected NPV is £70,000. However, this ignores the alternative course of action: to sell
the patent to another company for £90,000. This opportunity cost is a fundamental element in the investment decision to manufacture the product and should be deducted
from the £70,000, giving a negative NPV of £20,000. The in-house production option is
not wealth-creating – and the sale of the patent appears to be more attractive.
Opportunity cost example: Belfry plc
We often see opportunity costs in replacement decisions. In Belfry plc, an existing
machine can be replaced by an improved model costing £50,000, which generates cash
savings of £20,000 each year for five years, after which it will have a £5,000 scrap value.
The equipment manufacturers are prepared to give an allowance on the existing
machine of £15,000, making a net initial cash outlay of £35,000. But in pursuing this
course of action, we terminate the existing machine’s life, preventing it from yielding
£3,000 scrap value in three years. The prospective scrap value denied is the opportunity cost of replacing the existing machine. The cash flows associated with the replacement decision are therefore:
Year 0
Years 1–5
Year 3
Year 5
■
Net cost
Annual cash savings
Opportunity cost (scrap value forgone on old machine)
Scrap value on new machine
(£35,000)
(£20,000)
(£3,000)
£5,000
Ignore sunk costs
By definition, any costs incurred or revenues received prior to a decision are not relevant cash flows; they are sunk costs. This does not necessarily imply that previouslyincurred costs did not produce relevant information. For example, externally
conducted feasibility studies are often undertaken to provide important, technical, marketing and cost data prior to a major new investment. However, the costs of the study
are excluded from project analysis. We are concerned with future cash flows arising as
a particular consequence of the course of action.
■
Look for associated cash flows
Investment in capital projects may have company-wide cash flow implications. Those
involved in forecasting cash flows may not realise how the project affects other parts of
the business – senior management should therefore carefully consider whether there
are any additional cash flows associated with the investment decision. The decision to
produce and launch a new product may influence the demand for other products within the product range. Similarly, the decision to invest in a new manufacturing plant in
Eastern Europe, or to take over existing facilities, may have an adverse effect on the
company’s exports to such countries.
Self-assessment activity 6.2
Waxo plc has developed a new wonder earache drug. The management is currently putting
together an investment proposal to produce and sell the drug, but is not sure whether to
include the following:
1 The original cost of developing the drug.
2 Production of the new product will have an adverse effect on the sale of related products in another division of Waxo.
3 Instead of producing the drug internally, the patent could be sold for £10 million.
How would you advise Waxo on the relevant costs?
(Answer in Appendix A at the back of the book)
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150 Part II Investment decisions and strategies
■
Include working capital changes
It is easy to forget that the total investment for capital projects can be considerably more
than the fixed asset outlay. Normally, a capital project gives rise to increased stocks and
debtors to support the increase in sales. This increase in working capital forms part of the
investment outlay and should be included in project appraisal. If the project takes a number of years to reach its full capacity, there will probably be additional working capital
requirements in the early years, especially for new products where the seller may have to
tempt purchasers by offering more than usually generous credit terms. The investment
decision implies that the firm ties up fixed and working capital for the life of the project.
At the end of the project, whatever is realised is returned to the firm. For fixed assets, this
will be scrap or residual value – usually considerably less than the original cost, except in
the case of land and some premises. For working capital, the whole figure — less the
value of damaged stock and bad debts – is treated as a cash inflow in the final year,
because the finance tied up in working capital can now be released for other purposes.
Occasionally, the introduction of new equipment or technology reduces stock
requirements. Here the stock reduction is a positive cash flow in the start year; but an
equivalent negative outflow at the end of the project should be included only if it is
assumed that the firm will revert to the previous stock levels. A more realistic assumption may be that any replacement would at least maintain existing stock levels, in
which case no cash flow for stock in the final year is necessary.
■
Separate investment and financing decisions
Capital projects must be financed. Commonly, this involves borrowing, which requires
a series of cash outflows in the form of interest payments. These interest charges should
not be included in the cash flows because they relate to the financing rather than the
investment decision. Were interest payments to be deducted from the cash flows, it
would amount to double-counting, since the discounting process already considers the
cost of capital in the form of the discount rate. To include interest charges as a cash outflow could therefore result in seriously understating the true NPV.
Some companies include interest on short-term loans (such as for financing seasonal fluctuations in working capital) in the project cash flows. If so, it is important that
both the timing of the receipt and the repayment of the loan are also included. For
example, the NPV on a 15 per cent one-year loan of £100,000, assuming a 15 per cent
discount rate, must be zero: £100,000 cash received today less the present value of
interest and loan repaid after a year (i.e. £115,000/1.15).
■
Fixed overheads can be tricky
Only additional fixed overheads incurred as a result of the capital project should be
included in the analysis. In the short term, there will often be sufficient factory space
to house new equipment without incurring additional overheads, but ultimately some
additional fixed costs (for rent, heating and lighting, etc.) will be incurred. Most factories operate an accounting system whereby all costs, including fixed overheads, are
charged on some agreed basis to cost centres. Investment in a new process or machine
frequently attracts a share of these overheads. While this may be appropriate for
accounting purposes, only incremental fixed overheads incurred by the decision should
be included in the project analysis.
Self-assessment activity 6.3
Rick Faldo – the marketing manager of a manufacturer of golf equipment — has recently
submitted a proposal for the production of a range of clubs for beginners. He has just
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received the following response from the managing director:
To: Rick Faldo
From: Sid Torrance
I have examined your proposal for the new ‘Clubs for Beginners’ range which you say promises
a three-year payback and a 30 per cent DCF return. Some hope! You seem to have forgotten the
following relevant points.
1 We have a policy that all investment is subject to a depreciation charge of 25 per cent on
the reducing balance.
2 The accounting department will need to recover factory fixed overheads on the new
machine.
3 We need to charge against the project the £8,000 marketing research conducted to assess
the size of the market for the new range.
4 I’d have to pay 15 per cent to finance the project.
Projects like this I can do without!
How would you reply to this e-mail if you were Faldo?
(Answer in Appendix A at the back of the book)
6.3
REPLACEMENT DECISIONS
The decision to replace an existing machine which has yet to reach the end of its useful
life is often necessary because of developments in technology and generous trade-in
values offered by manufacturers. In analysing replacement decisions, we assess the
additional costs and benefits arising from the replacement, rather than the attractiveness of the new machine in isolation.
Example of replacement analysis: Sevvie plc
Sevvie plc manufactures components for the car industry. It is considering automating its
line for producing crankshaft bearings. The automated equipment will cost £750,000. It will
replace equipment with a residual value of £80,000 and a written-down book value of
£200,000. It is anticipated that the existing machine has a further five years to run, after
which its scrap value would be £5,000.
At present, the line has a capacity of 1.25 million units per annum but, typically, it
has only been run at 80 per cent of capacity because of the lack of demand for its output. The new line has a capacity of 1.4 million units per annum. Its life is expected to
be five years and its scrap value at that time £105,000. The main benefits of the new proposal are a reduction in staffing levels and an improvement in price due to its superior
quality.
The accountant has prepared the cost estimates shown in Table 6.1 based on output of
1 million units p.a. Fixed overheads include depreciation on the old machine of £40,000 p.a.
and £130,000 for the new machine. It is considered that for the company overall, other fixed
overheads are unlikely to change.
The introduction of the new machine will enable the average level of stocks held to
be reduced by £160,000. After five years, the machine will probably be replaced by a similar one.
Continued
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152 Part II Investment decisions and strategies
Table 6.1 Profitability of Sevvie’s project
Old line
(per unit)
(p)
Selling price
Materials
Labour
Variable overheads
Fixed overheads
Profit per unit
150
(40)
(22)
(14)
(34)
40
New line
(per unit)
(p)
155
(36)
(15)
(14)
(40)
50
The company uses a 10 per cent discount rate. We shall ignore taxation.
The solution is given in Table 6.2. Several comments are worthy of note:
1 It has been assumed that no benefits can be obtained from the additional capacity due to
the sales constraints. In reality, it would be useful to explore whether – for example, by
investing in advertising – demand could be increased.
2 Fixed costs are not relevant. Depreciation is not a cash flow, and we are told that other
fixed costs will not alter with the decision. The incremental cash flow per unit is therefore 16p, giving £160,000 (i.e. 1 million units at 16p) additional cash each year on the
expected sales.
3 In addition to the scrap values of £80,000 in Year 0 and £105,000 in Year 5 on the old
and new machines respectively, there is a £5,000 opportunity cost in Year 5. This is
the scrap value no longer available as a consequence of the replacement decision.
4 Working capital will be reduced by £160,000 for the period of the project and it therefore
appears as a benefit in Year 0.
5 The book value of the existing machine represents the undepreciated element of the
original cost, a sunk cost which is not relevant to the decision. The book value of assets,
however, may be important in practice, as it can sometimes mean a heavy accounting
loss in the year of acquisition. In this case, the loss would be £120,000 (i.e. book value
of £200,000 less £80,000 residual value). This is not a cash flow, but, in practice, it may
still be regarded as undesirable to depress reported profit figures in this way. This, of
course, raises issues of market efficiency – will the market see through the accounting
adjustment?
The replacement decision is a wealth-creating opportunity offering an NPV of £157,000,
although the cumulative present value calculation in Table 6.2 shows that the project does
not come into surplus, in net present value terms, until the final year.
Table 6.2 Sevvie plc solution
Selling price
Less:
Materials
Labour
Variable overheads
Variable costs
Cash contribution
Incremental cash flow
per unit (90–74)
Total incremental cash
flow on 1 million unit sales
Old line
(pence per unit)
New line
(pence per unit)
150
155
(40)
(22)
(14)
(76)
74
(36)
(15)
(14)
(65)
90
16p
£160,000
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Chapter 6 Project appraisal – applications
153
Table 6.2 Continued
Year (£000)
Cost savings
New machine
Scrap old machine
Working capital reduction
Net cash flow
Net present value
10% discount factor
Present value
Cumulative present value
NPV
6.4
0
(750)
80
160
(510)
1.000
(510)
(510)
157
1
160
2
160
3
160
4
160
5
160
105
(5)
160
160
160
160
260
0.751
120
(113)
0.683
109
(4)
0.909 0.826
145
132
(365) (233)
0.621
161
157
INFLATION CANNOT BE IGNORED
Inflation can have a major impact on the ultimate success or failure of capital projects.
In considering how it should be treated in discounted cash flow analysis, two problems
arise: first, how does inflation affect the estimated cash flows from the project; and second, how does it affect the discount rate?
For example, a machine costs £18,000 and is projected to produce, in current prices,
cash flows of £6,000, £10,000 and £7,000 respectively over the next three years. The
expected rate of inflation is 6 per cent and the firm’s cost of capital is 16.6 per cent.
We can adopt one of two approaches:
1 Forecast cash flows in money terms and discount at the nominal or money cost of
capital including inflation (i.e. 16.6 per cent), or
2 Forecast cash flows in constant (i.e. current) money terms and discount at the real
cost of capital.
‘Money terms’ here means the actual price levels that are forecast to obtain at the
date of each cash flow; ‘constant terms’ means the price level prevailing today; and
‘real cost of capital’ means the net of inflation cost.
In Table 6.3 cash flows expressed at constant prices are converted to actual money
cash flows by compounding at 11 I2, where I is the inflation rate. These cash flows are
then discounted in the normal manner at the money discount factor (the reason for such
an awkward rate will become apparent later) to give a positive NPV of £977. Had we
not adjusted cash flows for inflation, the NPV would have been incorrectly expressed
as a negative value.
Table 6.3
The money terms
approach
Year
0
Cash flow
current prices (£)
118,0002 1.0
Actual
money
prices (£)
Discount
factor
@ 16.6%
Present
value (£)
(18,000)
1
(18,000)
1
6,000 1.06
6,360
1
1.166
5,454
2
10,000 11.062 2
11,236
8,264
3
7,000 11.062 3
1
11.1662 2
8,337
1
11.1662 3
NPV
5,259
977
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154 Part II Investment decisions and strategies
In this example, we undertook both compounding and discounting. The process
could be simplified by multiplying the two elements. For example, in Year 2 we could
multiply 11.062 2 by 1> 11.1662 2 to obtain a net of inflation discount factor of 0.8264
which, when multiplied by the cash flow in current prices, gives a present value of
£8,264, as stated above. This gives rise to the formula for the real cost of capital, denoted
by P.
Calculating the real cost of capital
11 P2 1M
1I
or
P
1M
1
1I
where M is the money cost of capital, I is the inflation rate and P is the real cost of capital.
In our example, this gives us a real cost of capital of:
P
1.166
1 0.10, i.e. a rate of 10 per cent.
1.06
Applying the real cost of capital gives the same NPV as before, as shown in Table 6.4.
While the latter approach may be simpler, it is not without difficulties. In business,
the use of a single indicator of the rate of inflation, such as the Retail Price Index, may
be inappropriate. Selling prices, wage rates, material costs and overheads rarely
change at exactly the same rate each year. Rent may be fixed for a five-year period;
selling prices may be held for more than a year. Furthermore, when taxation is introduced into the analysis, we find that tax relief on capital investment is not subject to
inflation. Such complexities lead us to recommend that both cash flows and discount
rates should include inflation.
Self-assessment activity 6.4
What is the impact of firms not adjusting their investment ‘hurdle’ rates for changing levels
of inflation? How would you advise a company which employs a 20 per cent discount rate
which was based on a calculation made when inflation was twice the current level?
(Answer in Appendix A at the back of the book)
Table 6.4
The real terms
approach
Cash flow
current prices (£)
Real discount
rate @ 10%
0
(18,000)
1
6,000
2
10,000
1
1
1.1
1
11.12 2
3
7,000
Year
1
11.12 3
NPV
PV (£)
(18,000)
5,454
8,264
5,259
977
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6.5
155
TAXATION IS A CASH FLOW
In Chapter 2, we introduced the subject of taxation and its broad implications for financial management. In this section, we examine in greater depth the taxation considerations for capital investment projects.
Recall that in the UK, Corporation Tax is assessed by the Inland Revenue on the profits of the company after certain adjustments. While it is not calculated on a project basis
by the Inland Revenue, the actual tax bill will increase with every new project offering
additional profits and reduce with every project offering losses. Corporation Tax is
charged on the profits, gains and income of an accounting period, usually the period
for which accounts are made up annually. In arriving at taxable profits, a deduction is
made for capital allowances on certain types of capital investment. Following the principle outlined earlier of identifying the incremental cash flow, we need to ask: by how
much will the Corporation Tax bill for the company change each year as a result of the
decision? To answer this, we must consider the tax charged on project operating profits and the tax relief obtained on the capital investment outlay.
■
Taxation implications of Tiger 2000 for Woosnam plc
Woosnam plc invests in a new piece of equipment, the Tiger 2000, costing £40,000 on
1 January 2000. It intends to operate the equipment for four years when the scrap value
will be zero. Expected net cash flows from the project are £10,000 in the first year and
£20,000 for each of the next three years. The discount rate is 15 per cent and the rate of
Corporation Tax is 30 per cent.
No tax position
If we ignore taxation (perhaps Woosnam is making losses and is unlikely to pay tax for
some time), the net present value of the project’s pre-tax cash flows is £8,390, as shown in
Table 6.5. The positive NPV suggests that, on economic grounds, it should be accepted.
With Corporation Tax but no capital allowances
Most companies have to pay Corporation Tax, and a large company, like Woosnam plc,
will pay at the rate of 30 per cent of taxable profits. A recent change is that this tax is
now paid in the same year as the related profits, usually by quarterly instalments.
Hitherto, companies enjoyed a tax delay of at least a year, which meant that the tax payment would typically lag a full year behind the investment cash flows to which they
relate. Most investments attract a capital allowance (equivalent to a depreciation
charge) which reduces the tax bill. At this stage, we assume that the Tiger 2000 does not
attract any capital allowances.
Table 6.5
Project Tiger 2000
(assuming no capital
allowances)
Year
0
1
2
3
4
(1)
Pre-tax
cash flows
£
(2)
Tax @
30%
(3)
After-tax
cash flows
£
(4)
Discount
factor
@ 15%
(1 4)
PV
pre-tax
£
(3 4)
PV
post-tax
£
(40,000)
10,000
20,000
20,000
20,000
–
(3,000)
(6,000)
(6,000)
(6,000)
(40,000)
7,000
14,000
14,000
14,000
1.0
0.869
0.756
0.657
0.572
NPV
(40,000)
8,690
15,120
13,140
11,440
8,390
(40,000)
6,083
10,584
9,198
8,008
(6,127)
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156 Part II Investment decisions and strategies
Table 6.5 shows that after deducting tax to be paid, the NPV for the project falls
sharply to –£6,127. It is no longer economically viable.
With corporation tax and capital allowances
annual writing-down
allowances (WDAs)
Allowances for depreciation on
capital expenditure allowed for
tax purposes
For many types of capital investment, tax relief is granted on capital expenditure
incurred. In the United Kingdom, this is in the form of a first-year allowance and subsequent annual writing-down allowances (WDAs). The first-year allowance is a government incentive to encourage firms to invest and has in the past been as high as 100 per
cent. Currently, for large companies, it is as follows:
Plant and machinery
Industrial buildings
25 per cent on the reducing balance
4 per cent on the initial cost
So for expenditure on machinery of £1,000, the allowance would be as follows:
Year
1
2
3
Written-down value
at year-end (£)
Tax allowance (£)
25% 1,000 250
25% 750 188
25% 562 141, etc.
ˇ
ˇ
ˇ
ˇ
ˇ
ˇ
750
562
422, etc.
Clearly, the tax allowances diminish over time. Companies are allowed to write
assets down for tax purposes to their disposal value. Any discrepancy between writtendown value (WDV) and disposal value may trigger a tax liability (balancing charge)
or qualify for tax relief (balancing allowance). In the above example, disposal of the
asset for £500 after three years would mean that the capital allowances have been overgenerous to the extent of £78 (i.e. disposal value of £500 – WDV of £422). This balancing charge of £78 would then be subject to Corporation Tax. Disposal for, say, £300
would qualify the company for a balancing allowance of £122 (i.e. £422 – £300), a loss
that would be set against the taxable profits.
Let us return to the Woosnam plc example, this time assuming that the Tiger 2000
attracts a 25 per cent writing-down allowance. Table 6.6 calculates the WDAs. Tax is
payable in the same year as the investment cash flows to which they relate.
The difference between what the investment finally sold for (in this case zero) and
the balance at the start of the year is a balancing allowance, which is treated in the
Table 6.6
Woosnam plc – Tiger
2000 tax reliefs
End of
accounting year
1– Initial outlay
WDA at 25%
2– WDA at 25%
3– WDA at 25%
4– Sale proceeds
Balancing allowance
Tax written-down
value
£
40,000
10,000
30,000
7,500
22,500
5,625
16,875
–
16,875
Writing-down
allowance
£
30%
tax relief
£
10,000
3,000
7,500
2,250
5,625
1,688
16,875
40,000
5,062
12,000
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157
Table 6.7
Woosnam plc – Tiger
2000 with tax relief
Year
0
1
2
3
4
Pre-tax
cash flows
£
Tax at
30%
Tax relief
on WDA
£
Net cash
flows
£
Discount
factor 15%
PV
£
(40,000)
10,000
20,000
20,000
20,000
–
(3,000)
(6,000)
(6,000)
(6,000)
3,000
2,250
1,688
5,062
(40,000)
10,000
16,250
15,688
19,062
1.000
0.869
0.756
0.657
0.572
(40,000)
8,690
12,285
10,307
10,903
2,185
same way as the writing-down allowance. (We will not introduce further complications such as the election to pool plant and machinery in this book.) A useful check is
to see that the total WDA (column 3) equals the initial investment, and the tax benefit
(column 4) on this total corresponds, in this case £40,000 at 30% =£12,000.
These cash flows can then be added to the earlier example, as in Table 6.7, showing
that the investment offers a positive NPV of £2,185 after tax.
How would the after-tax NPV differ were Woosnam plc a small or medium-size
company? Such firms currently have a further tax incentive to invest by attracting a
40 per cent initial allowance, rather than 25 per cent. The effect is to reduce the tax bill
in the early years, deferring it to later years. Because later cash flows are less valuable,
this means that the NPV will increase.
Taxation therefore affects cash flows from investments. It is payable on taxable profits arising from the investment decision after deduction of capital allowances.
Self-assessment activity 6.5
Your boss says: ‘We only assess capital projects before tax. Every firm has to pay tax, so we
can ignore it’. Do you agree?
(Answer in Appendix A at the back of the book)
6.6
USE OF DCF TECHNIQUES
It is a common misconception that the discounted cash flow approach is a relatively
recent phenomenon. Historical records reveal an understanding of compound interest
(upon which discounted cash flow techniques are based) as far back as the Old
Babylonian period (c. 1800–1600 BC) in Mesopotamia. The earliest manuscripts setting
out compound interest tables date back to the 14th century, while the first recorded reference to the net present value rule is found in a book by Stevin published in 1582.
In these early days, the application of discounted cash flow methods was restricted
to financial investments such as loans and life assurance, where either the cash flows
were known or their probabilities could be determined based on actuarial evidence.
Only in the 19th century, with the Industrial Revolution well established, did the scale
of capital investments lead some engineering economists to begin to apply discounted
cash flow concepts to capital assets. However, in practice, these concepts were largely
ignored until the early 1950s in the USA and the early 1960s in the UK.
Surveys between 1975 and 1997 provide a clearer picture of the changing trends in
the practices of larger firms in the UK. Table 6.8 shows that, while all firms surveyed
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158 Part II Investment decisions and strategies
Table 6.8
Capital investment
evaluation methods in
100 large UK firms
Firms using:
Payback
Average accounting rate of return
DCF methods (IRR or NPV)
Internal rate of return
Net present value
1975
(%)
1981
(%)
1986
(%)
1992
(%)
1997
(%)
73
51
58
44
32
81
49
68
57
39
92
56
84
75
68
94
50
88
81
74
66
55
100
84
97
Sources: Pike (1988, 1996), Arnold and Hatzopoulos (2000)
conduct financial appraisals on capital projects, the choice of method varies considerably, and most firms employ a combination of appraisal techniques.
The use of DCF methods in larger firms increased greatly from 58 per cent in 1975
to 100 per cent by 1997. Hitherto, the IRR method enjoyed much greater popularity
than the theoretically preferred NPV approach. However, in recent years, there has
been a marked acceleration in adoption of the NPV method, with virtually all large
firms now employing it.
The payback method has declined in popularity in recent years, but remains more
popular with smaller firms. It is clear that firms do not normally rely on any single
appraisal measure, but prefer to employ a combination of simple and more sophisticated techniques. DCF methods therefore complement, rather than substitute for,
traditional approaches.
■
Dangers with DCF
While we have argued that DCF analysis offers a conceptually sound approach for
appraising capital projects, a word of caution is appropriate.
From the emphasis devoted by most textbooks to advanced capital budgeting methods, one might be forgiven for assuming that successful investment is exclusively
attributable to the correct evaluation method. However, DCF methods often create an
illusion of exactness that the underlying assumptions do not warrant. As top management places more weight on the quantifiable element, there is a danger that the
unquantifiable aspects of the decision, which frequently have a critical bearing on a
project’s success or failure, will be devalued. The human element is particularly
important with regard to the project sponsor. The margin between a project’s success
or failure often hinges on the enthusiasm and commitment of the person sponsoring
and implementing it.
Managers cannot afford to treat investment decisions in a vacuum, ignoring the
complexities of the business environment. Any attempt to incorporate such complexities, however, will at best consist of abstractions from reality relying on generalised
and simplified assumptions concerning business relationships and environments. A
fundamental assumption underlying DCF methods is that decision-makers pursue
the primary goal of maximising shareholders’ wealth. For many firms, this may not
be the case.
Critical errors may often be seen in the way DCF theory is applied by managers.
Usually, these errors are biased against investment. For example, many firms do not
adjust their operating cash flows for inflation, but discount them at the money cost of
capital, rather than the real rate of return before inflation. The effect is that cash flows
in later years (typically the strong positive cash flows) are unduly deflated by the high
discount factor, giving a lower net present value than should be the case.
Perhaps even more important, DCF methods ignore the value of investment options.
This key topic is the subject of Chapter 12.
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159
Common errors in applying DCF
■
■
■
■
■
■
■
■
6.7
Discount rates are calculated on a pre-tax basis, while operating cash flows are calculated after tax.
Discount rates are increased to compensate for non-economic statutory and welfare
investments.
Including interest charges in cash flows.
Cash flows are specified in today’s money (excluding inflation), while hurdle rates are
based on the money cost of capital (including inflation).
Managerial aversion to uncertainty frequently results in conservative project life and
terminal value assumptions.
Use of a single cut-off rate instead of a rate reflecting project risk. This often leads to
rejection of low-risk/low-return replacement projects.
Failure to include scrap values.
Neglect of working capital movements.
TRADITIONAL APPRAISAL METHODS
Managers have developed and come to rely upon simple rule-of-thumb approaches to
analysing investment worth. Two of the most popular traditional methods are the payback period and the accounting rate of return, both of which were described in earlier
chapters. Our present concern is to ask whether they have a valuable role to play in the
modern capital budgeting process. Do they offer anything to the decision-maker that
cannot be found in the DCF approaches?
■
Accounting rate of return (ARR)
We discussed the basic application of the ARR approach in Chapter 5. Table 6.8 reports
that a little over half the companies surveyed employ the accounting rate of return
approach in assessing investment decisions. This is not altogether surprising, given that
the rate of return on capital is a very important financial goal in practice.
The ARR can be criticised on at least two counts: it uses accounting profits rather
than cash flows, and it ignores the time-value of money. Nevertheless there has been
a certain amount of support for the ARR in the literature. The absence of ARR leads to
an inconsistency between the methods commonly used to report a firm’s results and
the techniques most frequently employed to appraise investment decisions. This is
most acutely experienced where the divisional manager of an investment centre is
expected to use a DCF approach in reaching investment decisions, while his or her
short-term performance is being judged on a return on investment basis. Little wonder, then, that the divisional manager generally shows a marked reluctance to enter
into any profitable long-term investment decisions that produce low returns in the
early years.
A common assumption among managers is that the accounting rate of return and
the internal rate of return produce much the same solutions. But while there is a relationship between a project’s discounted return and the ARR, the relationship is not
simple. Consider an investment costing £10,000 and generating an annual stream of
net cash flows of £3,000. Assuming straight-line depreciation, the relationship between
the internal rate of return and the accounting rate of return calculated on both the total
investment and the average investment is as shown in Table 6.9.
From this example we can see that the accounting rate of return on total investment
consistently understates, and the accounting rate of return on average investment overstates, the internal rate of return. The case for retaining the accounting rate of return is,
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160 Part II Investment decisions and strategies
Table 6.9
Relationship between
ARR and IRR
Project duration (years)
IRR (%)
ARR on total investment (%)
Deviation from IRR
ARR on average investment (%)
Deviation from IRR
5
15.2
10
5.2
20
4.8
10
27.3
20
7.3
40
12.7
20
25
29.8
25
4.8
50
20.2
30
27.5
2.5
55
25
therefore, valid only when applied as a secondary criterion to highlight the likely
impact on the organisation’s profitability upon which the divisional manager is
judged.
Residual income approach: Pluto Electronics
Residual Income
Operating profit less the charge
for capital
While the average accounting return can be a misleading decision indicator for capital
projects, it is possible to employ a profit-based approach that is in line with net present
value. This involves calculating the Residual Income (RI), the profit less a cost of capital
charge based on the book value of the assets employed.
Pluto Electronics has acquired the rights to manufacture a product for three years
and has set up a new division to do so. The investment outlay is £60 million and annual cash flows are forecast to be £30 million. The company operates a straight-line
depreciation policy and has a cost of capital of 10 per cent.
We can calculate the NPV (£m) as:
NPV 60 30 # PVIFA10,3 60 130 2.48682 £14.6 m
The same answer is given by calculating the residual income for each year and discounting at the cost of capital, as shown below. The annual profit is £10 million (i.e. £30
million cash flow less £20 million depreciation).
£m
Yr 1 profit
Investment outlay: £60 m
10% capital charge on investment
Residual income
Yr 2 profit
Book value of assets: £40 m
10% capital charge
Yr 3 profit
Book value of assets: £20 m
10% capital charge
Net present value
■
PV @ 10% (£m)
10
(6)
4
10
0.909 3.636
(4)
6
10
0.826 4.956
(2)
8
0.751 6.008
14.600
Payback period
Most finance texts have condemned the use of the payback period as potentially misleading in reaching investment decisions. However, Table 6.8 shows that it continues to
flourish, being employed by most firms surveyed. Typically, the payback period
required by firms is within 2–4 years (Arnold & Hatzopoulos 2000). Why is payback
so popular? Does it possess certain qualities not so apparent in more sophisticated
approaches?
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161
The two main objections to payback (PB)
1 It ignores all cash flows beyond the payback period.
2 It does not consider the profile of the project’s cash flows within the payback period.
Although such theoretical shortcomings could fundamentally alter a project’s ranking and
selection, the payback criterion possesses a number of merits.
1 PB estimates DCF return
The payback period provides a crude measure of investment profitability. When the
annual cash receipts from a project are uniform, the payback reciprocal is the internal
rate of return for a project of infinite life, or a good approximation to this rate for longlived projects.
IRR 1
payback period
In the case of very long-lived projects where the cash inflows are, on average, spread
evenly over the life of the project, the payback reciprocal is a reasonable proxy for the
internal rate of return. For example, a project offering permanent cash savings and giving a four-year payback period with relatively stable annual cash returns will have
approximately a 25 per cent internal rate of return (i.e. the reciprocal of payback period). However, if the project life is only ten years, the IRR would fall to 21 per cent –
some four percentage points below the payback reciprocal. In fact, the payback reciprocal consistently overstates the true rate of return for finite project lives.
2 PB considers uncertainty
Whereas more sophisticated techniques attempt to model the uncertainty surrounding
project returns, payback assumes that risk is time-related; the longer the period, the
greater the chance of failure. General economic uncertainty makes the task of forecasting cash flows extremely difficult; but for the most part, cash flows are correlated over
time. If the operating returns are below the expected level in the early years, they will
probably also be below plan in the later years.
Discounted cash flow, as practised in most firms, ignores this increase in uncertainty over time. Early cash flows, therefore, have an important information content on the
degree of accuracy of subsequent cash flows. By concentrating on the early cash flows,
the payback approach analyses the data where managers have greater confidence. If
such evaluation provides a different signal from DCF methods, it highlights the need
for a more careful consideration of the project’s risk characteristics.
3 PB as a screening device
Payback provides a relatively efficient method for ranking projects when constraints
prevail. The most obvious constraint is the time that managers can devote to initial
product screening. Only a handful of the investment ideas may stand up to serious and
thorough financial investigation. Payback period serves as a simple, first-level screening device which, in the case of marginal projects, tends to operate in their favour and
permits them to go forward for more thorough investigation.
Many firms also resort to payback period when experiencing liquidity constraints. Such a policy may make sense when funds are constrained and better
investment ideas are in the pipeline. The attractiveness of investment proposals
considered during the interim period will be a function more of their ability to pay
back rapidly than of their overall profitability. This does not necessarily lead to
optimal solutions.
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162 Part II Investment decisions and strategies
4 PB assists communication
Managers feel more comfortable with payback period than with DCF. In the first place,
it is simple to calculate and understand. The non-quantitative manager is reluctant to
rely on the recommendations of ‘sophisticated’ models when he or she lacks both the
time and expertise to verify such outcomes. Confidence in and commitment to a proposal depend to some degree on how thoroughly the evaluation model is comprehended. The payback method offers a convenient shorthand for the desirability of each
investment that is understandable at all levels of the organisation: namely, how quickly will the project recover its initial outlay? Some firms use a project classification system in which the payback period indicates how rapidly proposals should be processed
and put into operation.
Ultimately, it is the manager – not the method – who makes investment decisions
and is appraised on their outcome. Payback period is particularly attractive to managers not only because it is convenient to calculate and communicate, but also because
it signals good investment decisions at the earliest opportunity.
While the payback concept may lack the refinements of its more sophisticated evaluation counterparts, it possesses many endearing qualities that make it irresistible to
most managers; hence its resilience.
Self-assessment activity 6.6
The following reasons for using payback were made by finance executives from three different companies:
‘We use payback in support of other methods. It is not a sufficiently reliable tool to be
used in isolation.’
‘When liquidity is under pressure, payback is particularly relevant.’
‘Payback helps to give some idea of the riskiness of the project – a long time to get
one’s money back is obviously more risky than a short time.’
To what extent do you agree with these views?
■
The appropriate discount rate
So far the examples used have simply stated the project discount rate based on the cost
of capital, the rate of return required by investors. We discuss in some depth the appropriate discount rate in later chapters. Here, we outline one approach, the Weighted
Average Cost of Capital (WACC).
This measures the rate of return that the firm must achieve in order to satisfy all of
the people who invest in it. All of these investors incur an opportunity cost when placing their money in the hands of the firm’s managers. This is the rate of return they
could have achieved on the next best alternative investment.
Example
Wacky Ideas PLC Ltd produces novelty toys. It currently finances its business one-third
through loans and two-thirds through equity and reserves. Looking ahead it does not
expect to change this funding mix. The accountant estimates that the cost of equity is
12 per cent while the after-tax cost of borrowing is lower at 9 per cent. Given this information we can calculate the average cost of capital for the company, duly weighted
according to the proportion of capital represented by equity and borrowings respectively. For Wacky this is:
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Chapter 6 Project appraisal – applications
Source of capital
Proportion
Equity
Loans
WACC
67%
33%
Cost of capital
12%
9%
163
Weighted Cost
8%
3%
11%
The Weighted Average Cost of Capital (WACC) approach multiplies the cost of each
source of capital by the proportion of the total capital it represents. The results are
summed to provide a WACC estimate of 11 per cent in Wacky’s case. If we assume that
each new investment project receives a slice of the total capital in the same 2:1 equity:borrowing proportion, and that the project has the same level of risk as the typical
investments in the firm, we can apply a discount rate of 11 per cent in calculating the
project’s net present value. We leave the issue of determining the cost of capital for
each source of finance to a later chapter.
SUMMARY
One of the most difficult aspects of capital budgeting is identifying and gathering the
relevant information for analysis. This chapter has examined the incremental cash
flow approach to project analysis. Specific attention has been paid to the replacement
decision and to the impact of inflation and taxation on investment decisions.
Key points
■
Include only future, incremental cash flows relating to the investment decision and
its consequences. This implies the following:
1 Only additional fixed overheads are included.
2 Depreciation (a non-cash item) is excluded.
3 Sunk (or past) costs are not relevant.
4 Interest charges are financing (not investment) cash flows and are therefore
excluded from the cash flow profile.
5 Opportunity costs (e.g. the opportunity to rent or sell premises if the proposal is
not acceptable) are included.
■
Replacement decision analysis examines the change in cash flows resulting from the
decision to replace an existing asset with a new asset.
■
Inflation can have important effects on project analysis. Two approaches are possible: (1) specify all cash flows at ‘money-of-the-day’ (i.e. including inflation) prices
and discount at the money cost of capital, or (2) specify cash flows at today’s prices
and discount at the real (i.e. net of inflation) cost of capital. We recommend the former in most cases.
■
Taxation is for most organisations a cash flow. Tax is calculated by deducting any
cash benefits from tax relief on the initial capital expenditure from tax payable on
additional cash flows. Care should be taken in estimating the timing of tax cash
flows.
■
In practice, most firms, particularly larger companies, employ a combination of
DCF and traditional appraisal methods.
■
One way of estimating the discount rate to be used is to calculate the firm’s
Weighted Average Cost of Capital.
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164 Part II Investment decisions and strategies
Further reading
Most finance texts are not particularly strong on the applied aspects of capital budgeting.
Pohlman et al. (1988) describe cash flow estimation practices in large firms. Levy and Sarnat
(1994) has useful chapters, but the US tax system is employed. For a discussion on the investment appraisal criteria under low inflation, see the Bank of England (1994). Pointon (1980)
examines the effect of capital allowances on investment, while Hodgkinson (1989) surveys tax
treatment in corporate investment appraisal.
Studies on the investment practices of UK firms are well worth reading. See, for example, Pike
(1982, 1988, 1996), McIntyre and Coulthurst (1985), Mills (1988), Pike and Wolfe (1988) and
Arnold and Hatzopoulos (2000). Useful references on the capital budgeting process are Cooper
(1975), Pinches (1982) and Neale and Holmes (1991). Tomkins (1991) and Butler et al. (1993)
explore the strategic and organisational aspects in greater depth.
APPENDIX
THE PROBLEM OF UNEQUAL LIVES: ALLIS PLC
replacement chain
approach
The process of comparing likefor-like replacement decisions
for mutually exclusive projects
with different lives over a common time period
Comparing mutually exclusive projects – such as retaining the old asset or replacing it
with a new one – frequently involves the problem of assessing projects with different
economic lives.
Allis plc is seeking to modernise and speed up its production process. Two proposals have been suggested to achieve this: the purchase of a number of forklift trucks and
the acquisition of a conveyor system. The accountant has produced cost savings figures for the two proposals using a 10 per cent discount rate, shown in Table 6.10.
At first sight, the more expensive conveyor system appears more wealth-creating.
But it is not appropriate to compare projects with different lives without making some
adjustment. Two approaches can be employed for this: the replacement chain approach
and the equivalent annual annuity approach.
The replacement chain approach recognises that while, for convenience, we usually
consider only the time-horizon of the proposal, most investments form part of a
replacement chain over a much longer time-period. We therefore need to compare
mutually exclusive projects over a common period. In the example, this period is six
years, two forklift truck proposals (one following the other) being equivalent to one
conveyor system proposal. Assuming the cash flows for the original forklift trucks
also apply to their replacements in Year 4 (a pretty big assumption, given inflation,
Table 6.10
Allis plc cash flows for
two projects
Year
0
1
2
3
4
5
6
NPV at 10%
Forklift trucks
Conveyor system
(30,000)
10,000
15,000
18,000
(66,000)
12,000
20,000
20,000
18,000
15,000
15,000
6,538
5,010
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Chapter 6 Project appraisal – applications
165
improvements in technology, etc.), the replacement will produce a further NPV of
£5,010 at the start of Year 4.
To convert this to the present value (i.e. Year 0) we must discount this figure to the
present using the discount factor for 10 per cent for a cash flow three years hence:
PV £5,010 PVIF110,32 £5,010 0.7513 £3,764
The NPV for the forklift truck proposal, assuming like-for-like replacement after
three years, is therefore £5,010 £3,764 £8,774. This is well in excess of the NPV of
the conveyor system proposal (£6,538) over the same time-period.
Allis plc NPV comparison
Year
1–3
4–6
1–6
equivalent annual
annuity (EAA)
The constant annual cash
flow offering the same
present value as the project’s
net present value
Forklift trucks
£
Conveyor system
£
5,010
3,764
8,774
6,538
£5,010 0.7513
A second approach, the equivalent annual annuity (EAA) approach, is easier than its name
suggests. It seeks to determine the constant annual cash flow that offers the same present
value as the project’s NPV. This is found by dividing the project’s NPV by the relevant
annuity discount factor (i.e. 10 per cent over three years):
EAA NPV
PVIFA110,32
For the forklift proposal:
EAA £5,010
£2,015
2.4869
For the conveyor system proposal:
EAA £6,538
NPV
£1,501
PVIFA110,62
4.3553
The forklift proposal offers the higher equivalent annual annuity and is to be preferred.
Assuming continuous replacement at the end of their project lives, the NPVs for the projects over an infinite time-horizon are found by dividing the EAA by the discount rate:
NPV forklift truck £2,015>0.10 £20,150
NPV conveyor £1,501>0.10 £15,010
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166 Part II Investment decisions and strategies
QUESTIONS
Questions with a coloured number have solutions in Appendix B on page 695.
1 Most capital budgeting textbooks strongly recommend NPV, but most firms prefer IRR. Explain.
2 A project costing £20,000 offers an annual cash flow of £5,000 over its life.
(a) Calculate the internal rate of return using the payback reciprocal assuming an infinite life.
(b) Use tables to test your answer assuming the project life is (i) 20 years, (ii) eight years.
(c) What conclusions can be drawn as to the suitability of the payback reciprocal in measuring investment
profitability?
3 Your firm uses the IRR method and asks you to evaluate the following mutually exclusive projects:
Year
Cash flows (£)
Proposal L
Proposal M
0
1
2
3
4
47,232
47,232
20,000
0
20,000
10,000
20,000
20,000
20,000
65,350
Using the appropriate IRR method, evaluate these proposals assuming a required rate of return of 10 per cent.
Compare your answer with the net present value method.
4 State two ways in which inflation can be handled in investment analysis. Which way would you recommend
and why?
5 Bramhope Manufacturing Co. Ltd has found that, after only two years of using a machine for a semi-automatic process, a more advanced model has arrived on the market. This advanced model will not only produce
the current volume of the company’s product more efficiently, but allow increased output of the product. The
existing machine had cost £32,000 and was being depreciated straight-line over a ten-year period, at the end
of which it would be scrapped. The market value of this machine is currently £15,000 and there is a prospective purchaser interested in acquiring it.
The advanced model now available costs £123,500 fully installed. Because of its more complex mechanism,
the advanced model is expected to have a useful life of only eight years. A scrap value of £20,500 is considered reasonable.
A comparison of the existing and advanced model now available shows the following:
Capacity p.a.
Selling price per unit
Production costs per unit
Labour
Materials
Fixed overheads (allocation of
portion of company’s fixed overheads)
Existing machine
Advanced model
200,000 units
£
0.95
230,000 units
£
0.95
0.12
0.48
0.25
0.08
0.46
0.16
The sales director is of the opinion that additional output could be sold at 95p per unit.
If the advanced model were to be run at the old production level of 200,000 units per annum, the operators
would be freed for a proportionate period of time for reassignment to the other operations of the company.
The sales director has suggested that the advanced model should be purchased by the company to replace
the existing machine.
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Chapter 6 Project appraisal – applications
The required return is 15 per cent.
(i) You are required to calculate:
(a) payback period
(b) the net present value
(c) the internal rate of return (to the nearest per cent)
(ii) What recommendation would you make to the sales director? What other considerations are relevant?
6 Argon Mining plc is investigating the possibility of purchasing an open-cast coal mine in South Wales at a cost
of £2.5 million which the British Government is selling as part of its privatisation programme. The company’s
surveyors have spent the last three months examining the potential of the mine and have incurred costs to
date of £0.2 million. The surveyors have prepared a report which states that the company will require equipment and vehicles costing £12.5 million in order to operate the mine and that these assets can be sold for
£2.5 million in four years time when the coal reserves of the mine are exhausted.
The assistant to the Chief Financial Officer of the company has prepared the following projected profit and
loss accounts for each year of the life of the mine.
Projected Profit and Loss Accounts (£m)
Year
Sales
less Wages and salaries
Selling and distribution costs
Materials and consumables
Depreciation and equipment
Head office expenses
Survey costs
Interest charges
Net profit (loss)
1
2
3
4
9.4
(2.3)
(1.3)
(0.3)
(2.5)
(0.6)
(0.4)
(1.2)
0.8
9.8
(2.5)
(1.2)
(0.4)
(2.5)
(0.6)
8.5
(2.6)
(1.5)
(0.4)
(2.5)
(0.6)
6.3
(1.8)
(0.6)
(0.2)
(2.5)
(0.6)
(1.2)
1.4
(1.2)
(0.3)
(1.2)
(0.6)
In his report to the Chief Financial Officer, the assistant recommends that the company should not proceed
with the acquisition of the mine as the profitability of the proposal is poor.
The following additional information is available:
(i)
(ii)
(iii)
(iv)
(v)
(vi)
The project will require an investment of £0.5 million of working capital from the beginning of the project until the end of the useful life of the mine.
The wages and salaries expenses include £0.5 million of working capital in Year 1 for staff who are
already employed by the company but who would be without productive work until Year 2 if the project does not proceed. However, the company has no intention of dismissing these staff. After Year 1, these
staff will be employed on another project of the company.
One-third of the head office expenses consists of amounts directly incurred in managing the new project
and two-thirds represents an apportionment of other head office expenses to the project to ensure that it
bears a fair share of these expenses.
The survey costs include those costs already incurred to date, and which are to be written off in the first
year of the project, as well as costs to be incurred in the first year if the project is accepted.
The interest charges relate to finance required to purchase the equipment and vehicles necessary to carry
out the project.
After the mine has been exhausted, the company will be required to clean up the site and to make good
the damage to the environment resulting from its mining operations. The company will incur costs of
£0.4 million in Year 5 in order to do this.
The company has a cost of capital of 12 per cent.
Ignore taxation.
167
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168 Part II Investment decisions and strategies
Required
(a) Using what you consider to be the most appropriate investment appraisal method, prepare calculations
which will help the company to decide whether or not to proceed with the project.
(b) State, giving reasons, whether you think the project should go ahead.
(c) Explain why you consider the investment appraisal method selected in (a) above to be most appropriate
for evaluating investment projects.
7 Consolidated Oilfields plc is interested in exploring for oil near the west coast of Australia. The Australian
government is prepared to grant an exploration licence to the company for a five-year period for a fee of
£300,000 p.a. The option to acquire the rights must be taken immediately, otherwise another oil company will
be granted the rights. However, Consolidated Oilfields is not in a position to commence operations immediately, and exploration of the oilfield will not start until the beginning of the second year. In order to carry out
the exploration work, the company will require equipment costing £10,400,000, which will be made by a specialist engineering company. Half of the equipment cost will be payable immediately and half will be paid
when the equipment has been built and tested to the satisfaction of Consolidated Oilfields. It is estimated that
the second instalment will be paid at the end of the first year. The company commissioned a geological survey of the area and the results suggest that the oilfield will produce relatively small amounts of high-quality
crude oil. The survey cost £250,000 and is now due for payment.
The assistant to the project accountant has produced the following projected Profit and Loss Accounts for
the project for Years 2–5 when the oilfield is operational.
Year
2
£000
Sales
Less expenses
Wages and
salaries
Materials and
consumables
Licence fee
Overheads
Depreciation
Survey cost
written off
Interest charges
Profit
£000
7,400
3
£000
£000
8,300
4
£000
£000
9,800
5
£000
550
580
620
520
340
360
410
370
600
220
2,100
250
300
220
2,100
–
300
220
2,100
–
300
220
2,100
–
650
650
650
650
£000
5,800
4,710
4,210
4,300
3,160
2,690
4,090
5,500
2,640
The following additional information is available:
1 The licence fee charge appearing in the accounts in Year 2 includes a write-off for all the annual fee payable
in Year 1. The licence fee is paid to the Australian government at the end of each year.
2 The overheads contain an annual charge of £120,000, which represents an apportionment of head office
costs. This is based on a standard calculation to ensure that all projects bear a fair share of the central administrative costs of the business. The remainder of the overheads relate directly to the project.
3 The survey costs written off relate to the geological survey already undertaken and due for payment immediately.
4 The new equipment costing £10,400,000 will be sold at the end of the licence period for £2,000,000.
5 The project will require a specialised cutting tool for a brief period at the end of Year 2, which is currently
being used by the company in another project. The manager of the other project has estimated that he will
have to hire machinery at a cost of £150,000 for the period the cutting tool is on loan.
6 The project will require an investment of £650,000 working capital from the end of the first year to the end
of the licence period.
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Chapter 6 Project appraisal – applications
The company has a cost of capital of 10 per cent.
Ignore taxation.
Required
(a) Prepare calculations that will help the company to evaluate further the profitability of the proposed project.
(b) State, with reasons, whether you would recommend that the project be undertaken.
(c) Explain how inflation can pose problems when appraising capital expenditure proposals, and how these
problems may be dealt with.
(Certified Diploma)
8 You are the chief accountant of Deighton plc, which manufactures a wide range of building and plumbing fittings. It has recently taken over a smaller unquoted competitor, Linton Ltd. Deighton is currently checking
through various documents at Linton’s head office, including a number of investment appraisals. One of
these, a recently rejected application involving an outlay on equipment of £900,000, is reproduced below. It
was rejected because it failed to offer Linton’s target return on investment of 25 per cent (average profit-toinitial investment outlay). Closer inspection reveals several errors in the appraisal.
Evaluation of profitability of proposed project NT17
(all values in current year prices)
Item (£000)
Sales
Materials
Direct labour
Overheads
Interest
Depreciation
Profit pre-tax
Tax at 33%
Post-tax profit
Outlay
Stock
Equipment
Market research
Rate of return 0
(100)
(900)
(200)
(1,200)
Average profit
Investment
1
2
3
4
1,400
(400)
(400)
(100)
(120)
(225)
155
(51)
104
1,600
(450)
(450)
(100)
(120)
(225)
255
(84)
171
1,800
(500)
(500)
(100)
(120)
(225)
355
(117)
238
1,000
(250)
(250)
(100)
(120)
(225)
55
(18)
37
£138
11.5%
£1,200
You discover the following further details:
1 Linton’s policy was to finance both working capital and fixed investment by a bank overdraft. A 12 per cent
interest rate applied at the time of the evaluation.
2 A 25 per cent writing-down allowance (WDA) on a reducing balance basis is offered for new investment.
Linton’s profits are sufficient to utilise fully this allowance throughout the project.
3 Corporation Tax is paid a year in arrears.
4 Of the overhead charge, about half reflects absorption of existing overhead costs.
5 The market research was actually undertaken to investigate two proposals, the other project also having
been rejected. The total bill for all this research has already been paid.
6 Deighton itself requires a nominal return on new projects of 20 per cent after taxes, is currently ungeared
and has no plans to use any debt finance in the future.
Required
Write a report to the finance director in which you:
(a) Identify the mistakes made in Linton’s evaluation.
(b) Restate the investment appraisal in terms of the post-tax net present value to Deighton, recommending
whether the project should be undertaken or not.
(ACCA)
169
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170 Part II Investment decisions and strategies
9 (a) Explain how inflation affects the rate of return required on an investment project, and the distinction
between a real and a nominal (or ‘money terms’) approach to the evaluation of an investment project
under inflation.
(b) Howden plc is contemplating investment in an additional production line to produce its range of compact discs. A market research study, undertaken by a well-known firm of consultants, has revealed scope
to sell an additional output of 400,000 units p.a. The study cost £0.1 million, but the account has not yet
been settled.
The price and cost structure of a typical disc (net of royalties) is as follows:
£
Price per unit
Costs per unit of output
Material cost per unit
Direct labour cost per unit
Variable overhead cost per unit
Fixed overhead cost per unit
£
12.00
1.50
0.50
0.50
1.50
(4.00)
8.00
Profit
The fixed overhead represents an apportionment of central administrative and marketing costs. These
are expected to rise in total by £500,000 p.a. as a result of undertaking this project. The production line is
expected to operate for five years and require a total cash outlay of £11 million, including £0.5 million of
materials stocks. The equipment will have a residual value of £2 million. Because the company is moving towards a JIT stock management policy, it is expected that this project will involve steadily reducing
working capital needs, expected to decline at about 3 per cent p.a. by volume. The production line will
be accommodated in a presently empty building for which an offer of £2 million has recently been
received from another company. If the building is retained, it is expected that property price inflation will
increase its value to £3 million after five years.
While the precise rates of price and cost inflation are uncertain, economists in Howden’s corporate
planning department make the following forecasts for the average annual rates of inflation relevant to
the project:
Retail Price Index
Disc prices
Material prices
Direct labour wage rates
Variable overhead costs
Other overhead costs
6% p.a.
5% p.a.
3% p.a.
7% p.a.
7% p.a.
5% p.a.
Note: You may ignore taxes and capital allowances in this question.
Required
(a) Given that Howden’s shareholders require a real return of 8.5 per cent for projects of this degree of risk,
assess the financial viability of this proposal.
(b) Briefly discuss how inflation may complicate the analysis of business financial decisions.
(ACCA)
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Chapter 6 Project appraisal – applications
Practical assignment: Engineering Products case study
The following case study brings together many of the issues raised in Part 2 of this book on the analysis of strategic
investment decisions. In answering certain parts the student should also read Chapters 7 and 8.
Roger Davis, the newly appointed financial analyst of the Steel Tube division of Engineering Products plc, shut his
office door and walked over to his desk. He had just 24 hours to re-examine the accountant’s profit projections and
come up with a recommendation on the proposed new computer numerically controlled (CNC) milling machine.
At the meeting he had just left, the managing director made it quite clear: ‘If the project can’t pay for itself in the
first three years, it’s not worth bothering with.’ Davis was unhappy with the accountant’s analysis which showed
that the project was a loss maker. But as the MD said, ‘Unless you can convince me by this time tomorrow that
spending £240,000 on this capital project makes economic sense, you can forget the whole idea.’
His first task was to re-examine the accountant’s profitability forecast (Table 6.11) in the light of the following
facts that emerged from the meeting:
1 Given the rapid developments in the market, it was unrealistic to assume that the product had more than a
four-year life. The machinery would have no other use and could not raise more than £20,000 in scrap metal at
the end of the project.
2 The opening stock in Year 1 would be acquired at the same time as the machine. All other stock movement
would occur at the year ends.
3 This type of machine was depreciated over six years on a straight-line basis.
4 Within the ‘other production expenses’ were apportioned fixed overheads equal to 20 per cent of labour costs.
As far as could be seen, none of these overheads were incurred as a result of the proposal.
5 The administration charge was an apportionment of central fixed overheads.
Table 6.11
Profit projection for CNC milling machine (£000)
Year
1
2
3
4
Sales
Less costs
Materials
Opening stock
Purchases
Closing stock
400
600
800
600
40
260
(80)
80
300
(80)
80
360
(60)
60
240
–
Cost of sales
Labour
Other production expenses
Depreciation
Administrative overhead
Interest on loans to finance the project
220
80
80
40
54
22
300
120
90
40
76
22
380
120
92
40
74
22
300
80
100
40
74
22
Total cost
496
648
728
616
Profit (loss)
(96)
(48)
72
(16)
Later that day, Davis met the production manager, who explained that if the new machine was installed, it would
have sufficient capacity to enable an existing machine to be sold immediately for £20,000 and to create annual
cash benefits of £18,000. However, the accountant had told him that, with the machine currently standing in
the books at £50,000, the company simply could not afford to write off the asset against this year’s slender
profits. ‘We’d do better to keep it operating for another four years, when its scrap value will produce about
£8,000,’ he said.
Continued
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172 Part II Investment decisions and strategies
Davis then raised the proposal with the marketing director. It was not long before two new pieces of information
emerged:
(a) To stand a realistic chance of hitting the sales forecast for the proposal, marketing would require £40,000 for
additional advertising and sales promotion at the start of the project and a further £8,000 a year for the
remainder of the project’s life. The sales forecast and advertising effort had been devised in consultation with
marketing consultants whose bill for £18,000 had just arrived that morning.
(b) The marketing director was very concerned about the impact on other products within the product range. If
the investment went ahead, it would lead to a reduction in sales value of a competing product of around
£60,000 a year. ‘With net profit margins of around 10 per cent and gross margins (after direct costs) of 25
per cent on these sales, this is probably the “kiss of death” for the CNC proposal,’ Davis reflected.
The Steel Tube division was a profitable business operating within an attractive market. The investment, which
employed new technology, had recently been identified as part of the group’s core activities. The chief engineer
felt that once they had got to grips with the new technology it should deliver improved product quality, and
greater flexibility, enabling shorter production runs and other benefits.
The latest accounts for the division showed a 16 per cent return on assets, but the MD talked about a three-year
payback requirement. His phone call to the finance director at head office, to whom this proposal would eventually be sent, was distinctly unhelpful: ‘We have, in the past, found that whenever we lay down a hurdle rate for divisional capital projects, it merely encourages unduly optimistic estimates from divisional executives eager to promote their pet proposals. So now we give no guidelines on this matter.’
Davis decided to use 10 per cent as the required rate of return, made up of 6 per cent currently obtainable from
risk-free government securities plus a small element to compensate for risk. Davis went home that evening with a
very full briefcase and a number of unresolved questions.
1 How much of the information which he had gathered was really relevant to the decision?
2 What was the best approach to assessing the economic worth of the proposal? The company used payback
and return on investment, but he felt that discounted cash flow techniques had some merit.
3 Cash was particularly limited this year and acceptance of this project could mean that other projects would
have to be deferred. How should this be taken into consideration?
4 How should the strategic factors be assessed?
5 What about tax? Engineering Products plc pays Corporation Tax at 30 per cent and annual writing-down
allowances of 25 per cent on the reducing balance may be claimed. The existing machine has a nil value for tax
purposes and tax is payable in the same year as the cash flows to which it relates.
Required
Prepare the case, with recommendations, to be presented by Davis at tomorrow’s meeting. The report should
address points 1–5 above.
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7
Investment strategy and process
A Mickey Mouse investment?
The Euro Disney theme park opened with all the
razzmatazz of a Disney spectacular. However, from an
investment perspective, it was a spectacular flop in its
first few years of operation. It planned to make a profit in its opening year. Instead, Euro Disney produced
losses in each of its first three years, with the second
year producing a staggering loss of FFr 5.3 billion.
The park simply failed to attract sufficient visitors
to cover its initial costs. With only 12 million visitors
a year, the figure is still below the target of 13.3 million set back in 1996. The northern French climate,
rising franc, economic recession, Gallic hostility to
American culture and high admission cost all contributed to the lack of visitors.
After much huffing and puffing, Euro Disney
pulled off in September 2004 its second debt
restructuring in a decade, just in time to avoid
default by failing to meet the creditor deadline.
The latest financial rescue has resolved the immediate crisis at Europe’s biggest tourist attraction,
but has yet to guarantee its future (Financial Times,
2004, p. 20).
This seemed a far cry from its initial public offer
for shares launched on many of the stock exchanges
throughout Europe. The offer document indicated an
internal rate of return of 13.3 per cent between
1992 and 2017 based on an inflation assumption of
5 per cent per annum. A fairytale start to Euro
Disney life, followed by a financially delinquent adolescence – but would Euro Disney ever produce the
returns to make investors happy ever after? They are
still waiting.
Learning objectives
This chapter examines strategic issues in investment and the investment process:
■
How strategy shapes investment decisions.
■
Evaluating new technology and environmental projects.
■
The investment decision and control process.
■
Post-audit reviews.
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174 Part II Investment decisions and strategies
7.1
INTRODUCTION
A company’s ability to succeed in highly competitive markets depends to a great extent on
its ability to regenerate itself through wealth-creating capital investment decisions compatible with business strategy. In recent years, most of the combined internal and external
funds generated by UK firms have been committed to fixed capital investment. Applying
such resources to long-term capital projects in anticipation of an adequate return –
although a hazardous step – is essential for the vitality and well-being of the organisation.
7.2
STRATEGIC CONSIDERATIONS
Where do positive NPV projects come from? By definition, a positive NPV means that
a project offers returns superior to those obtainable in the capital market on investments of comparable risk. In the short run, it is quite feasible to find capital projects that
do just this, but in a competitive market it will not be long before other firms make similar investments, thereby ensuring that any superior returns are not perpetuated.
Selecting wealth-creating capital projects is no different from picking undervalued
shares on the stock market. Earlier discussion on market efficiency argued that this is
possible only if there are capital market imperfections that prevent asset prices reflecting their equilibrium values.
Companies that consistently create projects with high NPVs have developed a sustainable competitive advantage arising from imperfections in the product and factor
markets. These imperfections generally take the form of entry barriers that discourage
new entrants. Successful investments are therefore investments that help create, preserve or enhance competitive advantage.
Porter (1985) argues that there are really only three coherent strategies for strategic
business units:
1 To be the lowest-cost producer.
2 To focus on a niche or segment within the market.
3 To differentiate the product range so that it does not compete directly with lowercost products.
Investment expenditure that helps achieve the appropriate strategy is likely to generate superior returns. For example, Coca-Cola invests enormous sums into its product differentiation strategy through its brand support.
Capital projects should be viewed not simply in isolation, but within the context of
strategic portfolio analysis the business, its goals and strategic direction. This approach is often termed strategic
Assessing capital projects within portfolio analysis.
the strategic business context
The attractiveness of investment proposals coming from different sectors of the
and not simply in financial
terms
firm’s business portfolio depends not only on the rate of return offered, but also on
the strategic importance of the sector. Business strategies are formulated that involve
the allocation of resources (capital, labour, plant, marketing support etc.) to these
business units. The allocation may be based on analysis of the market’s attractiveness
McKinsey–General Electric and the firm’s competitive strengths, such as the McKinsey–General Electric portfolio
portfolio matrix
matrix outlined in Figure 7.1.
An approach for assessing projThe attractiveness of the market or industry is indicated by such factors as the size
ects within the wider strategic
context which focuses on the
and growth of the market, ease of entry, degree of competition and industry profmarket attractiveness and busiitability for each strategic business unit. Business strength is indicated by a firm’s marness strength of the product
and business unit relating to
ket share and its growth rate, brand loyalty, profitability, and technological and other
the capital proposal
comparative advantages. Such analysis leads to three basic strategies:
1 Invest in and strengthen businesses operating in relatively attractive markets. This
may mean heavy expenditures on capital equipment, working capital, research and
development, brand development and training.
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Chapter 7 Investment strategy and process
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Medium
INVEST
& GROW
INVEST
& GROW
Medium
Figure 7.1
High
INVEST
& GROW
Low
Market Attractiveness
High
Business Strength
IMPROVE
& DEFEND
(Selective
Investment)
IMPROVE
& DEFEND
(Selective
Investment)
HARVEST
OR DIVEST
Low
IMPROVE
& DEFEND
(Selective
Investment)
HARVEST
OR DIVEST
HARVEST
OR DIVEST
McKinsey–GE portfolio
matrix
2 Where the market is somewhat less attractive and the business less competitive (the
diagonal unshaded boxes), the business strategy is to get the maximum out of existing resources. The financial strategy is therefore to maximise or maintain cash flows,
while incurring capital expenditures mainly of a replacement nature. Tight control
over costs and management of working capital lead to higher levels of profitability
and cash flow.
3 The remaining businesses have little strategic quality and may, in the longer term,
be run down or divested unless action can be taken to improve their attractiveness.
The Japanese art of performance
Ask any Japanese business executive which company he or she
considers a role model and the
chances are high they will name
General Electric.
While few companies in Japan
have come anywhere near matching GE’s impressive record, Sanyo
Electric has been compared to the
US conglomerate for a distinctly
un-Japanese strategy: its habit of
rapidly ditching businesses that
fail to perform. The consumer
electronics maker has recently
transformed itself from an
industry also-ran, best known
for its low prices, to a technology
powerhouse focused on businesses where it has leadership in global markets.
Sanyo is the world’s largest
maker of digital still cameras,
with a 30 per cent share of the
market. It leads the global market in optical pick-ups – key components of CD and DVD players –
with its 40 per cent share and
has the top share in some 40
types of semiconductor. Sanyo’s
rechargeable batteries dominate
the market and can be found in
half the world’s mobile phones.
Moreover, the company has had
a string of innovative hits in the
FT
past few years. This transformation has contributed to a 21 per
cent rise in operating profits on
record sales. Yukinori Kuwano,
Sanyo’s chief executive, attributes
Sanyo’s recent success to its recent
efforts to be selective about where
it puts its resources. ‘Our main
aim (has been) to focus on products
that we are number one in globally’, says a smiling Mr Kuwano.
‘Unless you choose what to focus
on you will not be able to survive.’
Sanyo has adopted a system
that rates its businesses according
Continued
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176 Part II Investment decisions and strategies
to margins and growth potential.
Those offering low margins and
low growth prospects become
candidates for weeding out. ‘It’s
easy to say “concentrate and
select”, but you need a standard
for doing so,’ says Mr Kuwano.
Once a business is identified as
a ‘loser’ managers go through a
lengthy process of debate about
what to do with it. When, for
instance, Sanyo decided it had to
do something about a loss-making
vending machine business that
Boston Consulting Group
approach
An approach for assessing capital proposals based on the market growth and market share of
the products relating to the
proposal
was number two in its market,
managers considered several
options, including an acquisition
of one of its rivals, before deciding
to sell the business to its leading
competitor.
At the same time Sanyo led the
market in rechargeable batteries.
Since this was a promising sector
it decided to bolster its position by
acquiring Nippon Batteries’ lithium ion battery business and
Toshiba’s nickel metal hydride
business. Sanyo has thus managed
to streamline its businesses relatively quickly while ensuring staff
clearly understand the rationale
behind the decisions.
Critics point out that Sanyo
still has much work to do on its
lossmaking white-goods business.
If it can build a white-goods business with a strong global presence, Sanyo will have achieved a
feat that so far even GE has failed
to pull off.
Source: Michiyo Nakamoto, Financial Times,
18 May 2004, p. 12.
An alternative is the Boston Consulting Group approach, which describes the business portfolio in terms of relative market share and rate of growth (see Figure 7.2). This
matrix identifies four product markets within which a firm may operate: (1) ‘stars’
(high market share, high market growth), (2) ‘cash cows’ (high market share, low market growth), (3) ‘question marks’ (low market share, high market growth) and (4) ‘dogs’
(low market share, low market growth). The normal progression starts with the potentially successful product (‘question mark’) and moves in an anticlockwise direction,
eventually to be withdrawn (divested).
From this strategic analysis of the firm’s business portfolio, we suggest the pattern
of resource allocation outlined in Figure 7.3. Businesses offering high growth and the
possibility of acquiring market dominance are the main areas of investment (‘stars’
and ‘question marks’). Once such dominance is achieved, the growth rate declines and
investment is necessary only to maintain market share. These ‘cash cows’ become generators of funds for other growth areas. Business areas that have failed to achieve a
sizeable share of the market during their growth phase (‘dogs’) become candidates for
divestment and should be evaluated accordingly. Any cash so generated should be
applied to high-growth sectors.
Having developed its investment strategy, management can assess how individual
projects fit into the firm’s long-term strategic plan. Project appraisal – or, in the case of
capital shortage, project ranking – is not only judged according to rates of return.
Normal progression of
product over time
Low
High
Figure 7.2
High
‘STARS’
‘QUESTION
MARKS’
Low
Market Growth
Relative Market Share
‘CASH
COWS’
‘DOGS’
Divest
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Chapter 7 Investment strategy and process
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High
Low
Market Growth
Relative Market Share
High
Low
‘STARS’
(Invest)
‘QUESTION
MARKS’
(Invest)
‘CASH COWS’
(Funds Source)
‘DOGS’
Divest
(Source of funds)
Figure 7.3
Investment strategy
Many companies will reject projects offering high returns because projects fall outside
strategic thinking. Ultimately, the capital budget must tie up with corporate strategy
so that each project contributes to an element of that strategy.
In Chapter 4, we introduced Shareholder Value Analysis (SVA) as a valuable planning
tool and guide for strategic decision making. It is basically an extension of the NPV
approach where the focus is on business units, strategies and financial goals. A business
is viewed as a portfolio of investment projects, but the emphasis is placed on maximising
the value of strategic business units, not merely that of the capital projects within them.
Rather than dwell on short-term measures, such as annual earnings per share or
return on capital, SVA manages cash flows over time. It is this long-term cash flow that
determines the long-term value of the business. The value of adopting a new strategy
is assessed in terms of the difference in the value of the business before and after
implementation.
Self-assessment activity 7.1
Why is it important to view capital budgeting within a strategic framework?
(Answer in Appendix A at the back of the book)
Corporate mortality at Microsoft
Bill Gates is the world’s richest man and head of Microsoft, arguably the world’s most successful company. Yet he is brutally aware of his company’s vulnerability, even when most people
regard the business as an indomitable near monopolist at the heart of the software industry. As
he said recently: ‘Someday Microsoft will go out of business, it’s only a matter of time. Will it
happen in my lifetime, while I am still deeply involved in the company? I hope not. I wake up
every day working hard to reduce the probability of this. Companies are mortal’ (Bennet, 2001).
Gates realises that it is this awareness of corporate mortality that forces the company to
continue its punishing innovation cycle.
Over the years, there has been talk that Microsoft will use its vast cash resources and market capitalisation to diversify into other industries such as banking and telecoms. Gates rejects
this. So why has it been so successful? Of course, at one level, the main reason is its ability to
innovate and keep ahead of the competition. But Gates explains why the company has the
highest market capitalisation in terms of its high-volume, low-cost products.
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178 Part II Investment decisions and strategies
■
Project finance
Large-scale strategic projects, such as the construction of tunnels, roads and power stations, are often funded through project finance. Here the operation is financed and controlled separately from the operations of the constructor or user. The obvious benefit to
the company is that creditors of the project only have claims on the project’s cash flows,
not those of the companies involved in the construction process. Following the Private
Finance Initiative (PFI), which was introduced in the UK in 1992, many public sector
projects have been funded in this manner.
7.3
ADVANCED MANUFACTURING TECHNOLOGY (AMT) INVESTMENT
An area where strategic decision-making is often required is the evaluation of advanced
manufacturing technology projects. Strategic investment appraisal links corporate
strategy to the costs and benefits associated with AMT and other strategic decisions.
Frequently, it is insufficient to consider only financial issues; many of the benefits are
less tangible and hard to quantify.
The past 20 years have seen growth in new technology capital projects, creating different problems for the decision-maker. AMT projects offer a range of less tangible benefits: for example, greater flexibility with reduced ‘downtime’ on production changeover.
Greater flexibility enables businesses to meet the challenge of increasing competition,
shorter product life cycles and satisfying customers’ specific requirements. AMT offers a
flexible manufacturing system (FMS), in which a sequence of production operations are
computer-controlled to respond to ever-changing production and design requirements.
AMT terminology
AMT investment helps companies achieve competitive advantage through a number of
technologies:
■
Computer-aided design (CAD) helps the engineer test and modify a design from any
viewpoint.
■
Computer-integrated manufacture (CIM) brings together the manufacturing process and
the computer.
■
Computer-numerically controlled (CNC) machines can be easily reprogrammed to
perform different tasks.
■
Flexible manufacturing systems (FMS) enable the firm to produce a far greater variety of
components quickly.
■
Direct numerical control (DNC) systems connect a number of numerically controlled
machines by computer.
AMT example: Foster Engineering Ltd
Foster Engineering Ltd is considering introducing a flexible manufacturing system (FMS)
to modernise production in a department currently using conventional metal-working
machinery. The declining market and the awareness that its main competitors have
recently introduced new technology have made the need to modernise plant facilities an
urgent priority.
An AMT proposal has been put forward, offering an FMS capable of producing the
present output. It involves two machining centres with CNC lathes, a conveyor system for
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Chapter 7 Investment strategy and process
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transferring components and a computer for scheduling, tooling and overall control. The
total investment would cost £2.4 million, half being incurred at the start and the other
half after one year, at which point the existing machinery could be sold for £50,000. Any
benefit would arise from Year 2 onwards for five years. The two quantified benefits are
as follows:
1 A reduction in the number of skilled workers from 50 to 15. The annual cost of a skilled
worker is £20,000 (savings of 35 £20,000 = £700,000 p.a.).
2 Savings in scrap and re-work of £50,000 p.a.
The company requires all projects to offer a positive net present value discounted at
15 per cent.
The accountant produces the following evaluation showing that the FMS proposal has a
negative NPV of £159,000 and fails to meet corporate investment criteria:
FMS proposal
Annual benefit
PV at Year 1
PV at Year 0
(£000)
£700,000 PVIFA115%, 5 yrs2
£700,000 3.352
2,346
£2,346 PVIF115%, 1 yr2
£2,346 0.87
2,041
Initial investment
Year 0
Year 1 1£1,200 502 0.87
NPV
1£1,2002
1£1,0002
(2,200)
(159)
An incensed production engineer in Foster Engineering, on hearing that the proposal is
unacceptable, points to the ‘intangible’ benefits that the FMS will offer:
■
■
■
■
■
■
Improved quality leading to a significant, but unknown, reduction in sales returns
through faulty workmanship.
Reduced stock and work-in-progress, enabling improved shopfloor layout, greater space
and a lower working capital requirement.
Lower total manufacturing time, enabling the company to respond more quickly to customer orders and to reduce work-in-progress further.
Significantly improved machine utilisation rates, although the actual degree of improvement is difficult to quantify.
Increased capacity with the option to operate unmanned night workings.
Greater flexibility, enabling shorter production runs and faster re-tooling and
re-scheduling.
CIM involves the computerisation of functions and their integration into a system
that regulates the manufacturing process. It brings together the individual manufacturing techniques referred to earlier under unified computer control.
Many of these benefits could be quantified, at least in part (e.g. the savings in working capital), although the degree of confidence in the underlying assumptions may not
be high. But even so, there will still be a large intangible element that cannot be quantified. This has led to the charge that conventional methods of investment appraisal
are biased against AMT investments.
Kaplan (1986) raises the question of whether AMT projects must be ‘justified by
faith alone’. Should managers in Foster Engineering replace the DCF approach with a
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180 Part II Investment decisions and strategies
belief that AMT is the key to the future and that strategic positioning must override
economic analysis?
The answer is not to dismiss DCF analysis, but to see it within a wider strategic context. We advocate a three-stage approach to analysing AMT capital projects:
1 Does the project fit well within the company’s overall corporate strategy?
2 Does the DCF analysis, based on the quantifiable elements of the decision, justify
the investment outlay?
3 Where the net present value calculated in stage 2 is negative, examine the shortfall.
Does management believe that the ‘value’ of the intangible benefits exceeds the
shortfall? This last stage is essentially a subjective process whereby managers consider the strategic and operational benefits. No one can put an accurate value on
flexibility, for example, but it would be wrong to exclude such a major benefit from
consideration in the decision process.
Can firms afford not to invest?
Henry Ford once claimed: ‘If you need a new machine and don’t buy it, you pay for it without
getting it.’ The price paid is the loss in competitiveness from not taking advantage of new
technology.
In evaluating proposed investments, managers have turned increasingly to sophisticated
techniques. Their goal has been greater rationality in making investment decisions, yet their
accomplishment has often been quite different – serious under-investment in the capital stock
(the productive capacity, technology and worker skills) on which their companies rest. As a
result, they have unintentionally jeopardised their companies’ futures.
Ingersoll Milling Machine Company took a strategic view that it needed to invest in the latest technology. Each production department manager annually had to write a justification to
keep any machine that was over seven years old. The only generally accepted reason for not
replacing equipment was that a new machine did not offer any significant improvements over
older models.
7.4
ENVIRONMENTAL ASPECTS OF INVESTMENT
Much like AMT investment, many environmental capital projects have substantial costs
or benefits which may not be wholly reflected in conventional net present value analysis. It should be recalled, from Chapter 1, that shareholders are not the only stakeholders in the company and the needs of other stakeholders, including the wider community,
should also be incorporated into decisions. Environmental considerations have many
dimensions, including economic, political, technological and social.
Pollution issues will be covered by legislation and regulation, but often the directors will want to go beyond the statutory requirements. While costs are not difficult to
determine, the benefits are harder to quantify. For example, a greater sense of social
responsibility may be costly but could have long-term benefits if the enhanced corporate image results in more business and improved shareholder value.
The steps involved in evaluating projects with environmental implications are:
1 Evaluate the projects using conventional capital appraisal methods.
2 Identify and incorporate statutory environmental costs as part of the evaluation.
3 Assess the costs and benefits of other environmental measures. For example, introducing anti-pollution measures should help reduce compensation claims.
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Chapter 7 Investment strategy and process
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4 Specify the internal controls to be introduced to ensure that pollution, etc., is minimised during construction and implementation.
5 Assess the impact of the decision on shareholder wealth, ethical and social responsibility goals.
Does Shell take the longer view?
The Royal Dutch Shell group operates in 140 countries and invests over £8 billion annually in
oil exploration, refining and other capital projects. Most of its capital projects have sustainable
environmental implications.
Take a look at Shell’s annual report (www.shell.com) to examine the level of environmental
capital investment and provisions for cost of decommissioning and site restoration. What is its
policy on environmental investment and sustainable development? To what extent does Shell
take a long-term view on investment and consider wider social and environmental aspects?
Mattel boss wants you to be a Barbie girl in a Barbie world
Not many grown men will admit to playing with
dolls. For Robert Eckert, chairman and chief executive of Mattel, it is a daily activity. But then Mr
Eckert has been trying to develop ways of keeping his brands fresh instead of diversifying into
new ones.
It is a sign that Mattel is keeping up with the
times. This month, the world’s biggest toy company is gearing up to launch its latest Barbie doll.
The Multi-Ethnic Barbie is the most politically
correct doll to be launched yet and comes at a
sensitive time for the US following the war in
Afghanistan. Barbie is set to feature in Barbie as
Rapunzel, her second animated feature film, in the
hope of repeating the success of last year’s Barbie
in the Nutcracker. The film earned Barbie more
7.5
than $150 million in video sales, dolls and other
related merchandise last year.
When Eckert arrived at the helm last year, Mattel
had been struggling with poor earnings, senior
management defections and the botched acquisition of the Learning Company, a software group.
Eckert says, ‘But every time Mattel has strayed
from toys, it has done poorly. We are a toy brand,
that is what we know and that is our business’.
Mattel’s shareholders find it difficult to argue
against this strategy. Like Mr Eckert, the business
unit managers are on performance-related incentive schemes, all of which are linked to stock. ‘If
the company does well, we all do well. Otherwise
we don’t,’ he says.
Source: Based on Lina Saigol, Financial Times, 15 February 2002.
THE CAPITAL INVESTMENT PROCESS
So far we have focused on investment appraisal. Similar emphasis is found in much of
the capital budgeting literature, the assumption being that application of theoretically
correct methods leads to optimal investment selection and, hence, maximises shareholders’ wealth. The decision-maker is viewed as having a passive role, acting more as
a technician than as an entrepreneur. Somehow, investment ideas come to the surface;
various assumptions and cash flow estimates are made; and risk is incorporated within the discounting formula to produce the project’s net present value. If this is positive,
the proposal becomes part of the admissible set of investment possibilities. This set is
then further refined by the evaluation of mutually exclusive projects and the appraisal
of projects under capital rationing, where appropriate.
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182 Part II Investment decisions and strategies
Inherent in this approach to capital budgeting are the following assumptions, few
of which bear much relevance to the world of business:
1
2
3
4
5
Investment ideas simply emerge and land on the manager’s desk.
Projects can be viewed in isolation, i.e. projects are not interdependent.
Risk can be fully incorporated within the net present value framework.
Non-quantifiable or intangible investment considerations are unimportant.
Cash flow estimates are free from bias.
Increasingly, it has become apparent that the emphasis on investment appraisal
rather than on the whole capital investment process is misplaced and will not necessarily produce the most desirable investment programme. Investment decision-making
could be improved significantly if the emphasis were placed on asking the appropriate strategic question rather than on increasing the sophistication of measurement
techniques. Managers need to re-evaluate the investment procedures within their
organisations, not to determine whether they are aesthetically and theoretically correct, but to determine whether they allow managers to make better decisions.
Capital budgeting may best be understood as a process with a number of distinct
stages. Decision-making is an incremental activity, involving many people throughout the
organisational hierarchy, over an extended period of time. While senior management may
retain final approval, actual decisions are effectively taken much earlier at a lower level,
by a process that is still not entirely clear and that is not the same in all organisations.
Figure 7.4 shows the key stages in the capital budgeting process. The primary aim
of such a process is to ensure that available capital resources are distributed to wealthcreating capital projects that make the best contribution to corporate goals. A second
goal is to see that good investment ideas are not held back and that poor or ill-defined
proposals are rejected or further refined. We shall explore the following four stages:
1
2
3
4
■
Determination of the budget.
Search for, and development of, projects.
Evaluation and authorisation.
Monitoring and control.
Determination of the budget
In theory at least, all capital projects could be put to the capital market for funding
(individually or collectively as investment programmes), the availability of funds for
projects and rate of return required being a function of the market’s perception of the
prospective returns and associated risks. In practice, multi-divisional organisations
operate an internal capital market in which senior management is better informed than
the external capital market to assess capital proposals and allocate scarce resources.
If the investment decision-making body is a sub-unit of a larger group, the budget
may be more or less rigidly imposed on it from above. However, for quasi-autonomous
centres (divisions of larger groups with capital-raising powers) and/or independent
units, the amount to be spent on capital projects is largely under their control, subject,
of course, to considerations of corporate control and gearing.
■
Search for, and development of, projects
Economic theory views investment as the interaction of the supply of capital and the
flow of investment opportunities. It would be wrong, however, to assume that there is
a continuous flow of investment ideas. In general, the earlier an investment opportunity
is identified, the greater is the scope for reward.
Possibly the most important role which top management can play in the capital
investment process is to cultivate a corporate culture that encourages managers to
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Determination of the budget
– how much is available to spend?
Search and development
– what project ideas have emerged? (search)
– what costs and benefits will they generate? (screening)
– what type of project? (definition)
Evaluation
– what is the value of the projected costs and benefits?
– what is the target rate of return?
– does the project’s IRR exceed this?
(or does it have a positive NPV?)
– how risky is the project?
Authorisation
Monitoring and control
during implementation
– is the project on schedule?
– will costs exceed the budget?
ongoing
– is the project performing to budget?
post-auditing
– is the project performing to initial expectations?
– what lessons can we draw to assist future
appraisals?
Figure 7.4
A simple capital
budgeting system
search for, identify and sponsor investment ideas. Questions to be asked at the identification stage include the following:
1
2
3
4
How are project proposals initiated?
At what level are projects typically generated?
Is there a formal process for submitting ideas?
Is there an incentive scheme for identifying good project ideas?
Generating investment ideas involves considerable effort, time and personal risk
on the part of the proposer. Any manager who has experienced the frustration of having an investment proposal dismissed, or an accepted proposal fail, is likely to develop
an inbuilt resistance to creating further proposals unless the organisation culture
and rewards are conducive to such activity. There is some evidence (Larcker, 1983)
that firms adopting long-term incentive plans tend to increase their level of capital
investment.
For the identification phase of non-routine capital budgeting decisions, especially
those of a more strategic nature, to be productive, managers need to conduct environmental scanning, gathering information that is largely externally oriented. We should
not expect the formal information system within most organisations, which is set up
to help control short-term performance, to be particularly helpful in identifying nonroutine investment ideas.
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184 Part II Investment decisions and strategies
Preliminary screening
At this early stage, a preliminary screening of all investment ideas is usually conducted.
It is neither feasible nor desirable to conduct a full-scale evaluation of each investment
idea. The screening process is an important means of filtering out projects not thought
worthy of further investigation. Ideas may not fit with strategic thinking, or may fall
outside business units designated for growth or maintenance.
Screening proposals address such questions as the following:
1 Is the investment opportunity compatible with corporate strategy? Does it fall within a section of the business designated for growth, maintenance or divestment?
2 Are the resources required by the project available (expertise, finance, etc.)?
3 Is the idea technically feasible?
4 What evidence is there to suggest that it is likely to provide an acceptable return?
5 Are the risks involved acceptable?
As the quality of data used at the screening stage is generally poor, it makes little sense
to apply sophisticated financial analysis. Accordingly, the simple payback method is
frequently used at this stage because it offers a crude assessment of project profitability
and risk.
Project definition
Any investment proposal is vague and shapeless until it has been properly defined. At
the definition stage of the capital investment process, detailed specification of the
investment proposal involves the collection of data describing its technical and economic characteristics. For each proposal, a number of alternative options should be
generated, defined and, subsequently, appraised in order to create the project offering
the most attractive financial characteristics.
Even at this early stage, proposals are gaining commitment. The very act of collecting information necessitates communicating with managers who may either lend support or seek to undermine the proposal. The danger is that, in this process, commitments
are accumulated such that investment becomes almost inevitable. The amount of
information gathered for evaluation is largely determined by the following:
■
■
■
The data perceived as desirable to gain a favourable decision.
The ease and cost of its development.
The extent to which the proposer will be held responsible for later performance
related to the data.
Top management should seek to ensure that the most suitable projects are submitted
by managers through establishing mechanisms that induce behaviour congruence. The
accounting information system, reward system and capital budgeting procedures should
all encourage managers to put forward the proposals that top management is looking
for. For many firms, however, the accounting information system and reward mechanism encourage divisional managers to promote their own interests at the expense of
those of the organisation, and to emphasise short-term profit performance at the
expense of the longer term. Capital budgeting then becomes a ‘game’, with the accounting and reward systems as its rules. Cash flow estimates are biased to maximise the
gains to individuals within such rules.
Self-assessment activity 7.2
Outline the important stages in the capital budgeting process.
(Answer in Appendix A at the back of the book)
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185
Project classification
The information required and method of analysis will vary according to the nature of the
project. A suggested investment proposal classification is given below under the headings
replacement, cost reduction, expansion or improvement, new products, strategic, and
statutory and welfare.
Replacement proposals are justified primarily by the need to replace assets that are
nearly exhausted or have excessively high maintenance costs. Little or no
improvement may be expected from the replacement, but the expenditure is
essential to maintain the existing level of capacity or service (e.g. replacement of
vehicles). Engineering analysis plays an important role in these proposals.
Cost reduction proposals (which may also be replacement proposals) are intended to
reduce costs through addition of new equipment or modification to existing
equipment. Line managers and specialists (such as industrial engineers and
work study groups) should conduct a continuous review of production operations for profit improvement opportunities.
Expansion or improvement proposals relate to existing products, and are intended to
increase production, service and distribution capacity, to improve product quality, or to maintain and improve the firm’s competitive position.
New product proposals refer to all capital expenditures pertaining to the development
and implementation of new products.
Strategic proposals are generated at senior management level and involve expenditure in new areas, or where benefits extend beyond the investment itself. A project may appear to offer a negative net present value and yet still create further
valuable strategic opportunities. Three examples demonstrate this point:
1 Diversification projects may have the effect of bringing the company into a lower
risk category.
2 A patent may be acquired not for use within the firm, but to prevent its use by
competitors.
3 Where information is difficult to obtain, such as in overseas markets, it may make
sense to set up a small plant at a loss because it places the firm in a good position to
build up information and to be ready for minor investment at the appropriate time.
Statutory and welfare proposals do not usually offer an obvious financial return,
although they may contribute in other ways, such as enhancing the contentment,
and hence productivity, of the labour force. The main consideration is whether
standards are met at minimum cost.
Each proposal should be ranked within each category in terms of its effect on profits,
its degree of urgency, and whether or not it can be postponed.
■
Evaluation and authorisation
Evaluation
The evaluation phase involves appraisal of the project and decision outcome (accept,
reject, request further information, etc.). Project evaluation, in turn, involves the assembly of information (usually in terms of cash flows) and the application of specified
investment criteria. Each firm must decide whether to apply rigorous, sophisticated
evaluation models, or simpler models that are easier to grasp yet capture many of the
important elements in the decision.
The capital appropriation request forms the basis for the final decision to commit
financial and other resources to the project. Typical information included in an appropriation request is given below:
1 Purpose of project – why it is proposed, and the fit with corporate strategy and
goals.
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186 Part II Investment decisions and strategies
2 Project classification – e.g. expansion, replacement, improvement, cost saving, strategic, research and development, safety and health, legal requirement.
3 Finance requested – amount and timing, including net working capital, etc.
4 Operating cash flows – amount and timing, together with the main assumptions
influencing the accuracy of the cash flow estimates.
5 Attractiveness of the proposal – expressed by standard appraisal indicators, such as
net present value, DCF rate of return and payback period calculated from after-tax
cash flows.
6 Sensitivity of the assumptions – effect of changes in the main investment inputs. Other
approaches to assessing project risk should also be addressed (e.g. best/worst scenarios, estimated range of accuracy of DCF return, discussed in Chapter 8).
7 Review of alternatives – why they were rejected and their economic attractiveness.
8 Implications of not accepting the proposal – some projects with little economic merit
according to the appraisal indicators may be ‘essential’ to the continuance of a profitable part of the business or to achieving agreed strategy.
9 Non-financial considerations – those costs and benefits that cannot be measured.
Following evaluation, larger projects may require consideration at a number of
levels in the organisational hierarchy before they are finally approved or rejected.
The decision outcome is rarely based wholly on the computed signal derived from
financial analysis. Considerable judgement is applied in assessing the reliability of
data underlying the appraisal, fit with corporate strategy, and track record of the
project sponsor. Careful consideration is required regarding the influence on the
investment of such key factors as product markets, the economy, production, finance
and people.
Authorisation
Following evaluation, the proposal is transmitted through the various authorisation
levels of the organisational hierarchy until it is finally approved or rejected. The driving motive in the decision process is the willingness of the manager to make a commitment to sponsor a proposal. This is based not so much on the grounds of the
proposal itself as on whether or not it will enhance the manager’s reputation and career
prospects. Sometimes those involved in the preliminary investigation and appraisal of
major projects are promoted into head office decision-making positions in time to support and assist the approval of the same projects!
In larger organisations, the authorisation of major projects is usually a formal
endorsement of commitments already given. Complete rejection of proposals is rare,
but proposals are, on occasions, referred back. The approval stage appears to have a
twofold purpose:
1 A quality control function. As long as the proposals have satisfied the requirements
of all previous stages, there is no reason for their rejection other than on political
grounds. Only where the rest of the investment planning process is inadequate
will the approval stage take on greater significance in determining the destiny of
projects.
2 A motivational function. An investment project and its proposer are inseparable. The
decision-maker, in effect, forms a judgement simultaneously on both the proposal
and the person or team submitting it.
Sometimes the costs associated with rejection of capital projects, in terms of managerial motivation, far exceed the costs associated with accepting a marginally unprofitable project. The degree of commitment, enthusiasm and drive of the management
team implementing the project is a major factor in determining the success or failure
of marginal projects.
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187
MINI CASE
How SmithKline Beecham makes investments
In recent years, with more projects successfully reaching
late-development stage, the demands for funding at
SmithKline Beecham (now merged with Glaxo) were considerable. The pharmaceutical group, which invests more
than half a billion dollars annually, had to create more
value from its investments to help meet its tough earnings targets.
A new decision-making process was introduced,
designed to identify those development projects likely
to create the most value and reflect the complexity
and risk of its investments. Each project team was
asked to develop four alternatives: its current plans, a
‘buy-up’ option and a ‘buy-down’ option (where they
explored the effects of increasing and reducing the
investment outlay) and a minimum plan, where the
project was abandoned at minimum cost. These
alternatives were generated and valued before a
decision was taken.
A variety of decision approaches were taken, focusing
on creating net present value. These included decision
tree analysis, probability analysis, options analysis and
sensitivity analysis (discussed in the following chapters).
However, management soon discovered that equally
important were softer issues such as information quality,
credibility and trust.
It was their initial intention that this new resource allocation process would be useful in cutting the development budget. But they now saw investment decisions in a
new light and recognised that the investment portfolio
was worth far more than expected. The net result was an
increase in capital spending by more than 50 per cent.
Source: Based on Sharpe and Keelin, Harvard Business Review, March–April 1998.
Self-assessment activity 7.3
Read the above article and discuss the impact that a new resource allocation system can
have on capital investment creation, evaluation and decision-making.
■
Monitoring and control
The capital budgeting control process can be classified in terms of pre-decision and
post-decision controls. Pre-decision controls are mechanisms designed to influence
managerial behaviour at an early stage in the investment process. Examples are setting
authorisation levels and procedures to be followed, and influencing the proposals submitted by setting goals, hurdle rates and cash limits and identifying strategic areas for
growth. Post-decision controls include monitoring and post-audit procedures.
Major investment projects may justify determining the critical path (i.e. a set of
linked activities) in the delivery and installation schedule. The critical path is defined
as the longest path through a network. Control is established by accounting procedures for recording expenditures. Progress reports usually include actual expenditure;
amounts authorised to date; amounts committed against authorisations; amounts
authorised but not yet spent; and estimates of further cost to completion.
The case of the disappearing projects
Ameritech, a major US company operating in the electronics industry, invests over $2 billion a
year, mostly in thousands of relatively small-scale projects. When the company announced
that it proposed to monitor and audit capital projects, that year’s budgets had already been
submitted. But the company told every division to take back their submissions, think about the
Continued
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188 Part II Investment decisions and strategies
fact that everyone who worked on the project was going to be ‘tracked’, and then resubmit the
estimates. Seven hundred projects never came back – they just disappeared. Many others had
much lower estimates. We will never know just how many of those 700 projects could have
been investment ‘winners’.
This illustrates just how influential capital budgeting controls can be on managerial investment behaviour.
Source: Based on Weaver et al. (1989).
7.6
POST-AUDITING
post-audit
A re-examination of costs, benefits and forecasts of a project
after implementation (usually
after 1 year)
The final stage in the capital budgeting decision-making and control sequence is the
post-completion audit. UK firms have been considerably more hesitant in appreciating
the need to post-audit than their North American counterparts, although there is evidence that this is changing. In a survey conducted in 1985, Neale and Holmes (1988)
found that 48 per cent of large quoted UK companies had adopted post-audits. By
1997, the use of post-audits among large firms had risen to 100 per cent (Arnold and
Hatzopoulos, 2000), although mainly for major projects.
A post-audit aims to compare the actual performance of a project after, say, a year’s
operation with the forecast made at the time of approval, and ideally also with the
revised assessment made at the date of commissioning. The aims of the exercise are
twofold: first, post-audits may attempt to encourage more thorough and realistic
appraisals of future investment projects; and second, they may aim to facilitate major
overhauls of ongoing projects, perhaps to alter their strategic focus. These two aims
differ in an important respect. The first concerns the overall capital budgeting system,
seeking to improve its quality and cohesion. The second concerns the control of existing projects, but with a broader perspective than is normally possible during the regular monitoring procedure when project adjustments are usually of a ‘fire-fighting’
nature.
Self-assessment activity 7.4
What are the main benefits from post-audits?
(Answer in Appendix A at the back of the book)
■
Problems with post-auditing
There are many problems with post-audits:
1 The disentanglement problem. It may be difficult to separate out the relevant costs and
benefits specific to a new project from other company activities, especially where facilities are shared and the new project requires an increase in shared overheads. Newly
developed techniques of overhead cost allocation may prove helpful in this respect.
2 Projects may be unique. If there is no prospect of repeating a project in the future,
there may seem little point in post-auditing, since the lessons learned may not be
applicable to any future activity. Nevertheless, useful insights into the capital budgeting system as a whole may be obtained.
3 Prohibitive cost. To introduce post-audits may involve interference with present
management information systems in order to generate flows of suitable data. Since
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Chapter 7 Investment strategy and process
4
5
6
7
■
189
post-auditing every project may be very resource-intensive, firms tend to be selective in their post-audits.
Biased selection. By definition, only accepted projects can be post-audited, and often
only the underperforming ones are singled out for detailed examination. Because of
this biased selection mechanism, the forecasting and evaluation expertise of project
analysts may be cast in an unduly bad light – they might have been spot on in evaluating rejected and acceptably performing projects.
Lack of cooperation. If the post-audit is conducted in too inquisitorial a fashion, project sponsors are likely to offer grudging cooperation to the review team and be
reluctant to accept and act upon their findings. The impartiality of the review team
is paramount – for example, it would be inviting resentment to draw post-auditors
from other parts of the company that may be competitors for scarce capital. Similarly,
there are obvious dangers if reviews are undertaken solely by project sponsors. A
balanced team of investigators needs to be assembled.
Encourages risk-aversion. If analysts’ predictive and analytical abilities are to be thoroughly scrutinised, they may be inclined to advance only ‘safe’ projects where little
can go awry and where there is less chance of being ‘caught out’ by events.
Environmental changes. Some projects can be devastated by largely unpredictable
swings in market conditions. This can make the post-audit a complex affair, as the
review team is obliged to adjust analysts’ forecasts to allow for ‘moving of the
goalposts’.
The conventional wisdom
Studies conducted in North America and the UK have generated a conventional wisdom about corporate post-auditing practices. Its main elements are as follows:
■
■
■
■
■
Few firms post-audit every project, and the selection criterion is usually based on
size of outlay.
The commonest time for a first post-audit is about a year after project commissioning.
The most effective allocation of post-audit responsibility is to share it between central audit departments and project initiators to avoid conflicts of interest, while
using relevant expertise.
The ‘threat’ of post-audit is likely to spur the forecaster to greater accuracy, but it
can lead to excessive caution, possibly resulting in suppression of potentially
worthwhile ventures.
When does post-auditing work best?
What guidelines can we offer to managers who wish to introduce post-audit from
scratch or to overhaul an existing system? Here are some key points:
1 When introducing and operating post-audit, emphasise the learning objectives and
minimise the likelihood of its being viewed as a ‘search for the guilty’.
2 Clearly specify the aims of a post-audit. Is it to be primarily a project control exercise, or does it aim to derive insights into the overall project appraisal system?
3 When introducing post-audits, start the process with a small project to reveal as
economically as possible the difficulties that need to be overcome in a major
post-audit.
4 Include a pre-audit in the project proposal. When the project is submitted for
approval, the sponsors should be required to indicate what information would be
required to undertake a subsequent post-audit.
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190 Part II Investment decisions and strategies
SUMMARY
We have examined the strategic framework for investment decisions, paying particular attention to new technology and environmental projects.
The resource allocation process is the main vehicle by which business strategy can
be implemented. Investment decisions are not simply the result of applying some
evaluation criterion. Investment analysis is essentially a search process: a search for
ideas, for information and for decision criteria. The prosperity of a firm depends more
on its ability to create profitable investment opportunities than on its ability to
appraise them.
Key points
■
Investments form part of a wider strategic process and should be assessed both
financially and strategically.
■
New technology projects are often particularly difficult to evaluate because of the
many non-financial values.
■
The four main stages in the capital budgeting process are:
1
2
3
4
Determine the budget.
Search for and develop projects.
Evaluation and authorisation.
Monitoring and control.
Once a firm commits itself to a particular project, it should regularly and systematically monitor and control the project through its various stages of implementation.
■
Post-audit reviews, if properly designed, fulfil a useful role in improving the quality of existing and future investment analysis and provide a means of initiating corrective action for existing projects.
Further reading
Further reading on AMT investment evaluation is found in Finnie (1988), Pike et al. (1989) and
Kaplan (1986). Neale and Buckley (1992) consider the practice of post-auditing, while Butler
et al. (1993) examine strategic investment decisions.
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Chapter 7 Investment strategy and process
QUESTIONS
Questions with a coloured number have solutions in Appendix B on page 695.
1 ‘Capital budgeting is simply a matter of selecting the right decision rule.’ How true is this statement?
2 What are the aims of post-audits?
3 AMT plc is increasing the level of automation of a production line dedicated to a single product. The options
available are total automation or partial automation. The company works on a planning horizon of five years
and either option will produce the 10,000 units which can be sold annually.
Total automation will involve a total capital cost of £1 million. Material costs will be £12 per unit and labour
and variable overheads will be £18 per unit with this method.
Partial automation will result in higher material wastage and an average cost of £14 per unit. Labour and
variable overhead are expected to cost £41 per unit. The capital cost of this alternative is £250,000.
The products sell for £75 each, whichever method of production is adopted. The scrap value of the automated production line, in five years’ time, will be £100,000, while the line which is partially automated will
be worthless. The management uses straight-line depreciation and the required rate of return on capital
investment is 16 per cent p.a. Depreciation is considered to be the only incremental fixed cost.
In analysing investment opportunities of this type the company calculates the average total cost per unit,
annual net profit, the break-even volume per year and the discounted net present value.
Required
(a) Determine the figures which would be circulated to the management of AMT plc in order to assist their
investment analysis.
(b) Comment on the figures produced and make a recommendation with any qualifications you think appropriate.
(Certified Diploma)
4 Bowers Holdings plc has recently acquired a controlling interest in Shaldon Engineering plc, which produces
high-quality machine tools for the European market. Following this acquisition, the internal audit department
of Bowers Holdings plc examined the financial management systems of the newly acquired company and produced a report that was critical of its investment appraisal procedures.
The report summary stated:
Overall, investment appraisal procedures in Shaldon Engineering plc are very weak. Evaluation of capital
projects is not undertaken in a systematic manner and post-decision controls relating to capital projects are
virtually non-existent.
Required
Prepare a report for the directors of Shaldon Engineering plc, stating what you consider to be the major
characteristics of a system for evaluating, monitoring and controlling capital expenditure projects.
(Certified Diploma)
What procedures should a business adopt for approving and reviewing large capital expenditure projects?
Practical assignment
Read the Harvard Business Review article (Sept.–Oct. 1989) ‘Must finance and strategy clash?’ by Barwise, Marsh
and Wensley. Summarise and comment on their views on the question.
191
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Part
III
INVESTMENT RISK AND RETURN
The preceding analysis of investment decisions has implied that future returns from investment can
be forecast with certainty. Clearly, this is unlikely in practice. In Part III we examine the impact of
uncertainty on the investment decision, and the various approaches available to decision-makers to
cope with this problem.
In Chapter 8, we discuss a number of methods that may assist the decision-maker when looking at
the risky investment project in isolation. In Chapter 9, we look at how more desirable combinations
of risk and return can be achieved by forming a portfolio of investment activities. In Chapter 10, we
examine the contribution to risk analysis of the Capital Asset Pricing Model, which offers a guide to
setting the premium required for risk. The earlier study of how capital markets behave is particularly
important here. Chapter 10 is highly important because it links the behaviour of individual investors,
buying and selling securities, to the behaviour of the capital investment decision-maker. This focus is
further developed in Chapter 11, which discusses how to alter the discount rate when faced by
projects of degrees of risk that differ from the company’s existing activities. Finally, in Chapter 12,
we look at the contribution to investment appraisal under risk promised by the rapidly developing
field of option analysis.
Chapter 8
Analysing investment risk
Chapter 9
Relationships between investments: portfolio theory
195
219
Chapter 10 Setting the risk premium: the Capital Asset Pricing Model
Chapter 11 The required rate of return on investment and shareholder
value analysis 271
Chapter 12 Identifying and valuing options
296
237
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8
Analysing investment risk
Eurotunnel investors discover a black hole
In 1802, Napoleon turned down French mining engineer Matthieu Favier’s proposal for a Channel tunnel,
rising in the centre to a man-made island allowing
for a change of horses for the stage-coach traffic.
Many other schemes were subsequently rejected
until, in 1986, the Anglo-French Treaty was signed,
authorising the construction, financing and operation
of a twin rail tunnel system by Eurotunnel. The company is, effectively, a one-project business.
The preliminary prospectus provided forecasts
upon which expected returns and sensitivities could
be prepared. Potential investors and lenders were
asked to invest in a highly risky venture that would
not pay a dividend for at least eight years and where
the expected annual return was around 14 per cent.
The Economist commented at the time that the
Tunnel was ‘a hole in the ground that will either make
or lose a fortune’ for its investors. Throughout its
much-publicised history, Eurotunnel has struggled to
raise the necessary finances. The project’s construction
costs have more than doubled the original estimate,
while delays in completion and late delivery of trains
have held up revenue growth. On top of this, a major
fire on the supposedly safe freight carriages put it out
of operation and dented public confidence.
By 2000, things were looking a little better. The
chairman announced that the first dividend was
expected in 2006. However, closer questioning
revealed that this was the ‘upper case scenario’. In
the ‘lower case scenario’ dividend payments do not
begin until 2010. In 2005 the company is looking to
set up a rescue deal to pay for the interest charges
on the 6.4 billion it owes to 122 banks.
Those first investors who took a risk on either
making or losing a fortune saw Eurotunnel’s share
price plummet from 900p to 20p, and may have to
wait a quarter of a century before they receive their
first dividend! To the public, Eurotunnel may be a
hole in the ground, but to original investors it is a
massive hole in their pockets.
Learning objectives
The main learning objectives are the following:
■
To understand how uncertainty affects investment decisions.
■
To explore managers’ risk attitudes.
■
To appreciate the levels at which risk can be viewed.
■
To be able to measure the expected NPV and its variability.
■
To appreciate the main risk-handling techniques and apply them to capital budgeting problems.
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196 Part III Investment risk and return
8.1
INTRODUCTION
The Channel Tunnel is one of many cases where investment decisions turn out to be far
riskier than originally envisaged. The finance director of a major UK manufacturer for
the motor industry remarked, ‘We know that, on average, one in five large capital projects flops. The problem is: we have no idea beforehand which one!’
Stepping into the unknown – which is what investment decision-making effectively is – means that mistakes will surely occur. Entrepreneurs, on average, have nine
failures for each major success. Similarly, on average, nine empty oil wells are drilled
before a successful oil strike. Sir Richard Branson, head of Virgin Atlantic, once said,
‘the safest way to became a millionaire is to start as a billionaire and invest in the airline industry.’
This does not mean that managers can do nothing about project failures. In this and
subsequent chapters, we examine how project risk is assessed and controlled. The various forms of risk are defined and the main statistical methods for measuring project
risk within single-period and multi-period frameworks are described. A variety of risk
analysis techniques will then be discussed. These fall conveniently into methods intended to describe risk and methods incorporating project riskiness within the net present
value formula. The chapter concludes by examining the extent to which the methods
discussed are used in business organisations.
■
Defining terms
At the outset, we need to clarify our terms:
■
■
Certainty. Perfect certainty arises when expectations are single-valued: that is, a particular outcome will arise rather than a range of outcomes. Is there such a thing as
an investment with certain payoffs? Probably not, but some investments come fairly close. For example, an investment in three-month Treasury Bills will, subject to
the Bank of England keeping its promise, provide a precise return on redemption.
Risk and uncertainty. Although used interchangeably in everyday parlance, these
terms are not quite the same. Risk refers to the set of unique consequences for a
given decision that can be assigned probabilities, while uncertainty implies that it
is not fully possible to identify outcomes or to assign probabilities. Perhaps the
worst forms of uncertainty are the ‘unknown unknowns’ – outcomes from events
that we did not even consider.
The most obvious example of risk is the 50 per cent chance of obtaining a ‘head’ from
tossing a coin. For most investment decisions, however, empirical experience is hard to
find. Managers are forced to estimate probabilities where objective statistical evidence is
not available. Nevertheless, a manager with little prior experience of launching a particular product in a new market can still subjectively assess the risks involved based on the
information he or she has. Because subjective probabilities may be applied to investment
decisions in a manner similar to objective probabilities, the distinction between risk and
uncertainty is not critical in practice, and the two terms are often used interchangeably.
Investment decisions are only as good as the information upon which they rest.
Relevant and useful information is central in projecting the degree of risk surrounding
future economic events and in selecting the best investment option.
Self-assessment activity 8.1
Why is risk assessment important in making capital investment decisions?
(Answer in Appendix A at the back of the book)
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Chapter 8 Analysing investment risk
Table 8.1
Betterway plc: expected
net present values
Investment
A
B
C
8.2
NPV outcomes
(£)
Weighted outcomes
(£)
Probability
9,000
10,000
10,000
20,000
50,000
10,000
50,000
1
0.2
0.5
0.3
1.0
0.2
0.5
0.3
1.0
197
ENPV ENPV 9,000
2,000
5,000
6,000
9,000
11,000
5,000
15,000
9,000
EXPECTED NET PRESENT VALUE (ENPV): BETTERWAY PLC
To what extent is the net present value criterion relevant in the selection of risky investments? Consider the case of Betterway plc, contemplating three options with very different degrees of risk. The distribution of possible outcomes for these options is given
in Table 8.1. Notice that A’s cash flow is totally certain.
Clearly, while the NPV criterion is appropriate for investment option A, where the
cash flows are certain, it is no longer appropriate for the risky investment options B
and C, each with three possible outcomes. The whole range of possible outcomes may
expected net present value be considered by obtaining the expected net present value (ENPV), which is the mean
The average of the range of
of the NPV distribution when weighted by the probabilities of occurrence. The ENPV
possible NPVs weighted by
is given by the equation:
their probability of occurrence
N
X a piXi
i1
where X is the expected value of event X, Xi is the possible outcome i from event X, pi
is the probability of outcome i occurring and N is the number of possible outcomes.
The NPV rule may then be applied by selecting projects offering the highest expected net present value. In our example, all three options offer the same expected NPV of
£9,000. Should the management of Betterway view all three as equally attractive? The
answer to this question lies in their attitudes towards risk, for while the expected outcomes are the same, the possible outcomes vary considerably. Thus, although the expected NPV criterion provides a single measure of profitability, which may be applied to
risky investments, it does not, by itself, provide an acceptable decision criterion.
8.3
ATTITUDES TO RISK
Business managers prefer less risk to more risk for a given return. In other words, they
are risk-averse. In general, a business manager derives less utility, or satisfaction, from
gaining an additional £1,000 than he or she forgoes in losing £1,000. This is based on the
concept of diminishing marginal utility, which holds that, as wealth increases, marginal
utility declines at an increasing rate. Thus the utility function for risk-averse managers
is concave, as shown in Figure 8.1. As long as the utility function of the decision-maker
can be specified, this approach may be applied in reaching investment decisions.
■
Example: Carefree plc’s utility function
Mike Cool, the managing director of Carefree plc, a business with a current market
value of £30 million, has an opportunity to relocate its premises. It is estimated that
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198 Part III Investment risk and return
Risk-taker
Utility
Risk-indifferent
Risk-averter
Figure 8.1
Profit or wealth
Risk profiles
∆ UF
Utility
∆UA
Figure 8.2
Risk-averse investor’s
utility function
0
10
20
30
Wealth (£m)
42
there is a 50 per cent probability of increasing its value by £12 million and a similar
probability that its value will fall by £10 million. The owner’s utility function is outlined
in Figure 8.2. The concave slope shows that the owner is risk-averse. The gain in utility 1¢UF 2 as a result of the favourable outcome of £42 million, is less than the fall in utility 1¢UA 2 resulting from the adverse outcome of only £20 million.
The conclusion is that, although the investment proposal offers £1 million expected
additional wealth (i.e. 0.5 £12 m 0.5 (£10 m)), the project should not be undertaken because total expected utility would fall if the factory were relocated.
While decision-making based upon the expected utility criterion is conceptually
sound, it has serious practical drawbacks. Mike Cool may recognise that he is riskaverse, but is unable to define, with any degree of accuracy, the shape of his utility function. This becomes even more complicated in organisations where ownership and
management are separated, as is the case for most companies. Here, the agency problem
discussed in Chapter 1 arises. Thus, while utility analysis provides a useful insight into
the problem of risk, it does not provide us with operational decision rules.
8.4
THE MANY TYPES OF RISK
Risk may be classified into a number of types. A clear understanding of the different
forms of risk is useful in the evaluation and monitoring of capital projects:
1 Business risk – the variability in operating cash flows or profits before interest. A
firm’s business risk depends, in large measure, on the underlying economic environment within which it operates. But variability in operating cash flows can be
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Chapter 8 Analysing investment risk
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heavily affected by the cost structure of the business, and hence its operating gearing. A company’s break-even point is reached when sales revenues match total
costs. These costs consist of fixed costs – that is, costs that do not vary much with
the level of sales – and variable costs. The decision to become more capital-intensive
generally leads to an increase in the proportion of fixed costs in the cost structure.
This increase in operating gearing leads to greater variability in operating earnings.
Operating gearing example: Hifix and Lofix
Hifix and Lofix are two companies identical in every respect except cost structure. While
Lofix pays its workforce on an output-related basis, Hifix operates a flat-rate wage system.
The sales, costs and profits for the two companies are given under two economic states,
normal and recession, in Table 8.2. While both companies perform equally well under normal trading conditions, Hifix, with its heavier fixed cost element, is more vulnerable to
economic downturns. This can be measured by calculating the degree of operating gearing:
Operating gearing percentage change in profits
percentage change in sales
For Hifix 200%
5
40%
For Lofix 80%
2
40%
The degree of operating gearing is far greater for the firm with high fixed costs than for
the firm with low fixed costs. (Chapter 18 further discusses operating gearing.)
Table 8.2 Effects of cost structure on profits (£000)
Hifix
Normal
Sales
Variable costs
Fixed costs
Profit/loss
Change in sales
Change in profits
200
100
80
20
Lofix
Recession
120
60
80
20
40%
200%
Normal
Recession
200
160
20
20
120
96
20
4
40%
80%
2 Financial risk – the risk, over and above business risk, that results from the use of
debt capital. Financial gearing is increased by issuing more debt, thereby incurring
more fixed-interest charges and increasing the variability in net earnings. Financial
risk is considered more fully in later chapters.
3 Portfolio or market risk – the variability in shareholders’ returns. Investors can significantly reduce their variability in earnings by holding carefully selected investment portfolios. This is sometimes called ‘relevant’ risk, because only this element
of risk should be considered by a well-diversified shareholder. Chapters 9 and 10
examine such risk in greater depth.
Project risk can be viewed and defined in three different ways: (1) in isolation, (2) in
terms of its impact on the business, and (3) in terms of its impact on shareholders’
investment portfolios. One survey (Pike and Ho, 1991) found that 79 per cent of managers in larger UK firms use project-specific risk and 61 per cent consider the impact
of business risk, but only 26 per cent consider the impact on shareholder portfolios.
In this chapter, we assess project risk in isolation before moving on to estimate its
impact on investors’ portfolios (i.e. market risk) in Chapter 10.
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200 Part III Investment risk and return
Self-assessment activity 8.2
Which type of risk do the following describe:
1
2
3
4
Risks associated with increasing the level of borrowing?
The variability in the firm’s operating profits?
Variability in the cash flows of a proposed capital investment?
Variability in shareholders’ returns?
(Answer in Appendix A at the back of the book)
8.5
MEASUREMENT OF RISK
A well-known politician (not named to protect the guilty) once proclaimed, ‘Forecasting
is very important – particularly when it involves the future!’ Estimating the probabilities of uncertain forecast outcomes is difficult. But with the little knowledge the manager may have concerning the future, and by applying past experience backed by
historical analysis of a project and its setting, he or she may be able to construct a probability distribution of a project’s cash outcomes. This can be used to measure the risks
surrounding project cash flows in a variety of ways. If we assume that the range of possible outcomes from a decision is distributed normally around the expected value, riskaverse investors can assess project risk using expected value and standard deviation.
We shall consider three statistical measures: the standard deviation, semi-variance and
coefficient of variation for single-period cash flows.
■
Measuring risk for single-period cash flows: Snowglo plc
Table 8.3 shows the information on two projects for Snowglo plc.
Standard deviation
We have seen that expected value overlooks important information on the dispersion
(risk) of the outcomes. We also know that different people behave differently in risky
situations. Figure 8.3 shows the NPV distributions for projects A and B. Both projects
have the same expected NPV, indicated by M, but project A has greater dispersion. The
risk-averse manager in Snowglo will choose B since he or she wants to minimise risk.
The risk-taker will choose A because the NPV of project A has a chance (W ) of being
higher than X (which project B cannot offer), but also a chance (L) of being lower than Y.
Hereafter we make the reasonable assumption that most people are risk-averse.
The standard deviation is a measure of the dispersion of possible outcomes; the
wider the dispersion, the higher the standard deviation.
The expected value, denoted by X, is given by the equation:
N
X a piXi
i1
Table 8.3
Snowglo plc project
data
State of
economy
Strong
Normal
Weak
Probability
of outcome
0.2
0.5
0.3
Cash flow (£)
A
B
700
400
200
550
400
300
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Chapter 8 Analysing investment risk
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Probability
B
A
W
L
Figure 8.3
Variability of project
returns
Table 8.4
Project risk for
Snowglo plc
Y
Economic
state
M
X
NPV
Expected
Probability Outcome
value
(a)
(b)
1c a b2
Project A
Strong
Normal
Weak
0.2
0.5
0.3
700
400
200
140
200
60
XA 400
Project B
Strong
Normal
Weak
0.2
0.5
0.3
550
400
300
110
200
90
XB 400
Deviation
1d b X2
Squared
deviation
1e d2 2
Variance
1 f a e2
300
0
90,000
18,000
0
0
200
40,000
12,000
Variance s 2A 30,000
Standard deviation sA 173.2
150
0
22,500
4,500
0
0
10,000
3,000
100
Variance s 2B 7,500
Standard deviation sB 86.6
Alternatively:
XA 70010.22 40010.52 20010.32 400
sA 23 0.21700 4002 2 0.51400 4002 2 0.31200 4002 2 4
173.2
XA 55010.22 40010.52 30010.32 400
sB 23 0.21550 4002 2 0.51400 4002 2 0.31300 4002 2 4
86.6
and the standard deviation of the cash flows by:
s
N
2
a pi 1Xi X2
B i1
Table 8.4 provides the workings for projects A and B.
Applying the formulae, we obtain an expected cash flow of £400 for both project
A and project B. If the decision-maker had a neutral risk attitude, he or she would
view the two projects equally favourably. But as the decision-maker is likely to be
risk-averse, it is appropriate to examine the standard deviations of the two probability distributions. Here we see that project A, with a standard deviation twice that
of project B, is more risky and hence less attractive. This could have been deduced
simply by observing the distribution of outcomes and noting that the same probabilities apply to both projects. But observation cannot always tell us by how much
one project is riskier than another.
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202 Part III Investment risk and return
Semi-variance
While deviation above the mean may be viewed favourably by managers, it is ‘downside risk’ (i.e. deviations below expected outcomes) that is mainly considered in the
decision process. Downside risk is best measured by the semi-variance, a special case
of the variance, given by the formula:
K
SV a pj 1Xj X2 2
j1
where SV is the semi-variance, j is each outcome value less than the expected value, and
K is the number of outcomes that are less than the expected value.
Applying the semi-variance to the example in Table 8.4, the downside risk relates
exclusively to the ‘weak’ state of the economy:
SVA 0.31200 4002 2 £12,000
SVB 0.31300 4002 2 £3,000
Once again project B is seen to have a much lower degree of risk. In both cases, the
semi-variance accounts for 40 per cent of the project variance.
Coefficient of variation (CV)
Where projects differ in scale, a more valid comparison is found by applying a relative
risk measure such as the coefficient of variation. The lower the CV, the lower the relative degree of risk. This is calculated by dividing the standard deviation by the expected value of net cash flows, as in the expression:
CV s>X
The Snowglo example (Table 8.4) gives the following coefficients:
Project A
Project B
Standard deviation
(1)
Expected value
(2)
Coefficient of variation
(1 2)
£173.2
£86.6
£400
£400
0.43
0.22
Both projects have the same expected value, but project B has a significantly lower
degree of risk. Next, we consider the situation where the two projects under review are
different in scale:
Standard deviation
Project F
Project G
£1,000
£2,000
Expected value
£10,000
£40,000
Coefficient of variation
0.10
0.05
Although the absolute measure of dispersion (the standard deviation) is greater for
project G, few people in business would regard it as more risky than project F because
of the significant difference in the expected values of the two investments. The coefficient of variation reveals that G actually offers a lower amount of risk per £1 of expected value.
Self-assessment activity 8.3
Project X has an expected return of £2,000 and a standard deviation of £400. Project Y
has an expected return of £1,000 and a standard deviation of £400. Which project is
more risky?
(Answer in Appendix A at the back of the book)
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Chapter 8 Analysing investment risk
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Mean–variance rule
Given the expected return and the measure of dispersion (variance or standard deviation), we can formulate the mean–variance rule. This states that one project will be preferred to another if either of the following holds:
1 Its expected return is higher and the variance is equal to or less than that of the other
project.
2 Its expected return exceeds or is equal to the expected return of the other project and
the variance is lower.
This is illustrated by the mean–variance analysis depicted in Figure 8.4. Projects A
and D are preferable to projects C and B respectively because they offer a higher return
for the same degree of risk. In addition, A is preferable to B because for the same expected return, it incurs lower risk. These choices are applicable to all risk-averse managers
regardless of their particular utility functions. What this rule cannot do, however, is distinguish between projects where both expected returns and risk differ (projects A and
D in Figure 8.4). This important issue will be discussed in Chapters 9 and 10.
Expected value
D
Figure 8.4
0
B
A
C
Variance
Mean–variance analysis
So far, our analysis of risk has assumed single-period investments. We have conveniently ignored the fact that, typically, investments are multi-period. The analysis of
project risk where there are multi-period cash flows is discussed in the appendix to
this chapter.
■
Risk-handling methods
There are two broad approaches to handling risk in the investment decision process.
The first attempts to describe the riskiness of a given project, using various applications
of probability analysis or some simple method. The second aims to incorporate the
investor’s perception of project riskiness within the NPV formula.
We turn first to the various techniques available to help describe investment risk.
Self-assessment activity 8.4
What do you understand by the following?
(a) risk
(b) uncertainty
(c) risk-aversion
(d) expected value
(e) standard deviation
(f) semi-variance
(g) mean–variance rule
(Answer in Appendix A at the back of the book)
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204 Part III Investment risk and return
Discount
rate
Capital
cost
NPV
Price
Market size
4,000
3,000
2,000
1,000
–25 –20
–15 –10 –5 0
5
10
15
20 25
% Deviation
from expected
value
–1,000
Figure 8.5
–2,000
Sensitivity graph
8.6
■
RISK DESCRIPTION TECHNIQUES
Sensitivity analysis
In principle, sensitivity analysis is a very simple technique, used to locate and assess
the potential impact of risk on a project’s value. It aims not to quantify risk, but to identify the impact on NPV of changes to key assumptions. Sensitivity analysis provides the
decision-maker with answers to a whole range of ‘what if’ questions. For example,
what is the NPV if selling price falls by 10 per cent? What is the IRR if the project’s life
is only three years, not five years as expected? What is the level of sales revenue
required to break even in net present value terms?
Sensitivity graphs permit the plotting of net present values (or IRRs) against the percentage deviation from the expected value of the factor under investigation. The sensitivity graph in Figure 8.5 depicts the potential impact of deviations from the expected
values of a project’s variables on NPV. When everything is unchanged, the NPV is £2,000.
However, NPV becomes zero when market size decreases by 20 per cent or price decreases by 5 per cent. This shows that NPV is very sensitive to price changes. Similarly, a 10
per cent increase in the capital cost will bring the NPV down to zero, while the discount
rate must increase to 25 per cent in order to render the project uneconomic. Therefore, the
project is more sensitive to capital investment changes than to variations in the discount
rate. The sensitivity of NPV to each factor is reflected by the slope of the sensitivity line –
the steeper the line, the greater the impact on NPV of changes in the specified variable.
Sensitivity analysis is widely used because of its simplicity and ability to focus on
particular estimates. It can identify the critical factors that have greatest impact on a
project’s profitability. It does not, however, actually evaluate risk; the decision-maker
must still assess the likelihood of occurrence for these deviations from expected values.
Break-even sensitivity analysis: UMK plc
The accountant of UMK plc has put together the cash flow forecasts for a new product with
a four-year life, involving capital investment of £200,000. It produces a net present value, at
a 10 per cent discount rate, of £40,920. His basic analysis is given in Table 8.5. Which factors are most critical to the decision?
Investment outlay
This can rise by up to £40,920 (assuming all other estimates remain unchanged) before the
decision advice alters. This is a percentage increase of
£40,920
100 20.5%
£200,000
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Chapter 8 Analysing investment risk
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Table 8.5 UMK cost structure
Unit data
Selling price
Less: Materials
Labour
Variable costs
Contribution
Annual sales (units)
Total contribution
Less: Additional fixed costs
Annual net cash flow
Present value (4 years at 10%)
£
£
20
(6)
(5)
(1)
(12)
8
12,000
76,000 3.17
Less: Capital outlay
Net present value
96,000
(20,000)
76,000
240,920
(200,000)
40,920
Annual cash receipts
The break-even position is reached when annual cash receipts multiplied by the annuity factor equal the investment outlay. The break-even cash flow is therefore the investment outlay divided by the annuity factor:
£200,000
£63,091
3.17
This is a percentage fall of
£76,000 £63,091
17.0%
£76,000
Annual fixed costs could increase by the same absolute amount of £12,909, or
£12,909
100 64.5%
£20,000
Annual sales volume the break-even annual contribution is £63,091 £20,000 £83,091.
Sales volume required to break even is £83,091/£8 10,386, which is a percentage
decline of
12,000 10,386
100 13.5%
12,000
Selling price can fall by:
£96,000 £83,091
£1.07 per unit
12,000
a decline of
£1.07
100 5.4%
£20
Variable costs per unit can rise by a similar amount:
£1.07
100 8.9%
£12
Continued
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206 Part III Investment risk and return
Discount rate
The break-even annuity factor is £200,000/£76,000=2.63. Reference to the present value
annuity tables for four years shows that 2.63 corresponds to an IRR of 19 per cent. The error
in cost of capital calculation could be as much as nine percentage points before it affects the
decision advice.
Sensitivity analysis, as applied in the above example, discloses that selling price and
variable costs are the two most critical variables in the investment decision. The decision-maker must then determine (subjectively or objectively) the probabilities of such
changes occurring, and whether he or she is prepared to accept the risks.
■
Scenario analysis
Sensitivity analysis considers the effects of changes in key variables only one at a time.
It does not ask the question: ‘How bad could the project look?’ Enthusiastic managers
can sometimes get carried away with the most likely outcomes and forget just what
might happen if critical assumptions – such as the state of the economy or competitors’
reactions – are unrealistic. Scenario analysis seeks to establish ‘worst’ and ‘best’ scenarios, so that the whole range of possible outcomes can be considered. It encourages ‘contingent thinking’, describing the future by a collection of possible eventualities.
New risks put scenario planning in favour
Who could have predicted the
horrific events of September 11,
2001? A 1999 US congressional
commission led by former senators Gary Hart and Warren
Rudman came close. It warned
that the US was ‘increasingly vulnerable to attack on our homeland’ and that ‘rapid advances in
information and biotechnologies
will create new vulnerabilities’.
But perhaps more important
than the commission’s prophetic
messages was its approach.
Instead of forecasting a specific
future, it set out a collection of
possible attack scenarios. It then
evaluated national security by
analysing possible policies to prepare for, or respond to them.
This approach – known as
scenario planning – has gained
renewed popularity among public and private decision-makers.
In January this year, the New
England Journal of Medicine published a scenario planning analysis
on whether US health workers or
the whole nation should be vaccinated against smallpox to counter
the threat of bio-terrorism. President George W. Bush decided to
inoculate 500,000 military personnel and 439,000 health workers.
Scenario planners face three
challenges. The first is constructing meaningful scenarios. This
requires expert analysis of the
factors that affect the outcomes. A
second challenge is determining
the likelihoods of the scenarios.
Finally, planners must decide
on a good criterion for selecting
strategies. Most individuals and
institutions are risk-averse: they
value an uncertain reward at a
level significantly below the average level the reward in fact reaches. Strategies with higher average
pay-offs often entail greater risks.
Hence, scenario planning often
involves analysing the reward at
different levels of risk – much as
is done in financial planning.
FT
What explains the recent interest in scenario planning? For one
thing, we live in turbulent times.
Terrorism, political instability
and threats of war make scenarios of extreme price fluctuations
in commodity and energy markets more likely. Severe acute respiratory syndrome, ‘mad cow
disease’ and foot-and-mouth disease have rekindled awareness of
the natural biological threats we
face. Accounting scandals force us
to second-guess what used to be
considered accurate information
about suppliers and customers. In
short, companies face far greater
risks than before. Indeed, when
Mattel used scenario planning to
formulate its 2002 strategy, it
considered scenarios with several
big customers (such as Kmart,
FAO and eToys) going bankrupt
and others (Wal-Mart) starting to
make their own toys.
Source: Awi Federgruen and Garrett Van Ryzin,
Financial Times, 19 August 2003, p. 11.
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207
Simulation analysis
Monte Carlo simulation
Method for calculating the
probability distribution of
possible outcomes
An extension of scenario analysis is simulation analysis. Monte Carlo simulation is an
operations research technique with a variety of business applications. The computer
generates hundreds of possible combinations of variables according to a pre-specified
probability distribution. Each scenario gives rise to an NPV outcome which, along with
other NPVs, produces a probability distribution of outcomes.
One of the first writers to apply the simulation approach to risky investments was
Hertz (1964), who described the approach adopted by his consultancy firm in evaluating a major expansion of the processing plant of an industrial chemical producer. This
involved constructing a mathematical model that captured the essential characteristics
of the investment proposal throughout its life as it encountered random events.
A simulation model might consider the following variables, which are subject to
random variation.
Market factors
Investment factors
Market size
Investment outlay
Cost factors
Variable costs
Market growth rate
Selling price of product
Project life
Residual value
Fixed costs
Market share captured by the firm
Comparison is then possible between mutually exclusive projects whose NPV probability distributions have been calculated in this manner (Figure 8.6). It will be observed
that project A, with a higher expected NPV and lower risk, is preferable to project B.
Frequency
A
B
Figure 8.6
Simulated probability
distributions
0
NPV
In practice, few companies use this risk analysis approach, for the following reasons:
1 The simple model described above assumes that the economic factors are unrelated.
Clearly, many of them (e.g. market share and selling price) are statistically interdependent. To the extent that interdependency exists among variables, it must be specified. Such interrelationships are not always clear and are frequently complex to model.
2 Managers are required to specify probability distributions for the exogenous variables. Few managers are able or willing to accept the demands required by the simulation approach.
Self-assessment activity 8.5
What do you understand by Monte Carlo simulation? When might it be useful in capital
budgeting?
(Answer in Appendix A at the back of the book)
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208 Part III Investment risk and return
8.7
ADJUSTING THE NPV FORMULA FOR RISK
Two approaches are commonly used to incorporate risk within the NPV formula.
■
Certainty equivalent method
This conceptually appealing approach permits adjustment for risk by incorporating the
decision-maker’s risk attitude into the capital investment decision. The certainty equivalent method adjusts the numerator in the net present value calculation by multiplying
the expected annual cash flows by a certainty equivalent coefficient. The revised formula becomes:
Certainty equivalent method
N
aXt
NPV a
t Io
t1 11 i2
where: NPV is the expected net present value; a is the certainty equivalent coefficient,
which reflect’s management’s risk attitude; Xt is the expected cash flow in period t; i is
the riskless rate of interest; n is the project’s life; and Io is the initial cash outlay.
The numerator 1aXt 2 represents the figure that management would be willing to
receive as a certain sum each year in place of the uncertain annual cash flow offered
by the project. The greater is management’s aversion to risk, the nearer the certainty
equivalent coefficient is to zero. Where projects are of normal risk for the business, and
the cost of capital and risk-free rate of interest are known, it is possible to determine
the certainty equivalent coefficient.
Example
Calculate the certainty equivalent coefficient for a normal risk project with a one-year
life and an expected cash flow of £5,000 receivable at the end of the year. Shareholders
require a return of 12 per cent for projects of this degree of risk and the risk-free rate of
interest is 6 per cent.
The present value of the project, excluding the initial cost and using the 12 per cent
discount rate, is:
PV £5,000
£4,464
1 0.12
Using the present value and substituting the risk-free interest rate for the cost of
capital, we obtain the certainty equivalent coefficient:
a £5,000
£4,464
1 0.06
1£4,4642 11.062
a
£5,000
0.9464
The management is, therefore, indifferent as to whether it receives an uncertain
cash flow one year hence of £5,000 or a certain cash flow of £4,732 (i.e. £5,000 0.9464).
■
Risk-adjusted discount rate
Whereas the certainty equivalent approach adjusted the numerator in the NPV formula,
the risk-adjusted discount rate adjusts the denominator:
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Cash-flow (£)
Chapter 8 Analysing investment risk
209
Expected
cash flow
Figure 8.7
How risk is assumed to
increase over time
2
4
6
Time (years)
8
10
Risk-adjusted discount rate method
N
Xt
NPV a
Io
11
k2 t
t1
where k is the risk-adjusted rate based on the perceived degree of project risk.
The higher the perceived riskiness of a project, the greater the risk premium to be added to
the risk-free interest rate. This results in a higher discount rate and, hence, a lower net
present value.
Although this approach has a certain intuitive appeal, its relevance depends very
much on how risk is perceived to change over time. The risk-adjusted discount rate
involves the impact of the risk premium growing over time at an exponential rate, implying that the riskiness of the project’s cash flow also increases over time. Figure 8.7 demonstrates this point. Although the expected cash flow from a project may be constant over
its ten-year life, the riskiness associated with the cash flows increases with time. However,
if risk did not increase with time, the risk-adjusted discount rate would be inappropriate.
Adjusting the discount rate: Chox-Box Ltd
Chox-Box Ltd is a manufacturer of confectionery currently appraising a proposal to launch
a new product that has had very little pre-launch testing. It is estimated that this proposal
will produce annual cash flows in the region of £100,000 for the next five years, after which
product profitability declines sharply. As the proposal is seen as a high-risk venture, a 12
per cent risk premium is incorporated in the discount rate. The risk-adjusted cash flow,
before discounting at the risk-free discount rate, is therefore £89,286 in Year 1 (£100,000/1.12),
falling to £56,742 in Year 5 (£100,000/1.125).
To what extent does this method reflect the actual riskiness of the annual cash flows for
Years 1 and 5? Arguably, the greatest uncertainty surrounds the initial launch period. Once
the initial market penetration and subsequent repeat orders are known, the subsequent
sales are relatively easy to forecast. Thus, for Chox-Box, a single risk-adjusted discount rate
is a poor proxy for the impact of risk on value over the project’s life, because risk does not
increase exponentially with the passage of time, and, in some cases, actually declines over
time. The Eurotunnel project provides another illustration of this. By far the greatest risks
were in the initial tunnelling and development phases.
A deeper understanding of the relationship between the certainty equivalent and riskadjusted discount rate approaches may be gained by reading the appendix to this chapter.
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210 Part III Investment risk and return
8.8
RISK ANALYSIS IN PRACTICE
To what extent do companies employ the techniques discussed in this chapter? Table 8.6
shows changes over the past twenty-five years.
Sensitivity analysis and best/worst case (or scenario) analysis are conducted in
almost all larger UK companies. Approximately one half of larger firms adjust the discount rate for risk. Less common, however, are techniques requiring managers to
assign probabilities to possible outcomes; managers prefer to assess the likelihood of
outcomes in a more subjective manner. Finally, there is little real evidence that Beta
analysis (based on the Capital Asset Pricing Model and discussed in Chapter 10) is
used extensively in industry.
Table 8.6
Risk analysis in 100
large UK firms
1975 (%)
1980 (%)
1986 (%)
1992 (%)
1997 (%)
28
n.a.
25
37
9
–
42
n.a.
30
41
10
–
71
93
61
61
40
16
86
95
59
64
47
20
89
n.a.
11
50
42
5
Sensitivity analysis
Best/worst case analysis
Reduced payback period
Risk-adjusted rate
Probability analysis
Beta analysis
Source: Pike (1996), Arnold and Hatzopoulos (2000)
MINI CASE
The big gamble: Airbus rolls out its new weapon in its battle with Boeing
The biggest bet placed by Europe’s aerospace industry was
officially launched in January 2005. The Airbus A380 – a
twin-decked behemoth with seats for 555 passengers – was
rolled out in Toulouse and gives the company a complete
range of models to challenge Boeing, ending the lucrative
monopoly Boeing has had in the very large aircraft market
for 35 years.
Noel Forgeard, Airbus chief executive, says the company
had made a ‘successful metamorphosis to a world leader’.
He claims the group is almost twice as profitable as
Boeing’s commercial airplanes division, helped by a ‘huge,
relentless effort to reduce unit cost and grow our productivity: it is the reason why we can gain market share and
grow profitably.’
Boeing has certainly looked increasingly vulnerable. The
group’s critics say its long years of success led to complacency and it allowed the pace of product innovation to
slow as it prioritised short-term earnings over investment.
‘Boeing has struggled with the development work needed
to take the company into the 21st century,’ says Tim
Clark, president of Emirates, the Dubai-based airline that
is one of the world’s most important buyers of long-haul
aircraft and will be the biggest operator of the Airbus
A380.
Airbus’s A380 ‘will change the game for long-haul airlines and airports,’ says Chris Avery, aviation analyst at JP
Morgan. ‘With operating costs 15 per cent below the
B747-400, we believe A380 operations will have an advantage on long-haul services in markets between Europe and
Asia, across the Pacific and across the Atlantic.’ Boeing,
however, thinks the A380 is a white elephant, designed for
a world that no longer needs aircraft of such great size.
Airbus has 149 orders so far, still short of the 250 that it
estimates are needed to give a profit. The $11 billion
investment of public and private money is a huge gamble.
Boeing and Airbus agree that air traffic over the next 20
years is expected to increase annually on average by about
5 per cent. But they differ greatly on how airlines will
accommodate that. Boeing’s vision is based on the ‘fragmentation’ of aviation markets, reflecting passengers’ preference for more point-to-point, non-stop services and more
frequent services instead of being routed to destinations via
connecting hubs. Airbus accepts that fragmentation, but it
also expects consolidation on the main trunk routes.
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Chapter 8 Analysing investment risk
Airbus seems to be winning the argument. In recent
years, it has won over some operators that previously used
only Boeing aircraft. But Airbus still has plenty to prove. In
Japan, Boeing reigns supreme. There, the government and
the aerospace industry are backing Boeing’s 7E7.
Another challenge is the weakness of the dollar against
the euro. This has the potential to undermine its long-term
competitiveness. For most of 2005 and 2006 Airbus is protected, having hedged about $40 billion of revenues at
around ;1>$1. It has also taken the precaution of pricing
most of its purchases in dollars – even in Europe –
thereby transferring exchange risk to suppliers. Gerald Blanc,
Airbus executive vice-president operations, warned, ‘This will
probably impair our ability to invest as much in research and
development as we have done so far.’
211
A third challenge is Airbus’s ability to show it will not be
thrown off course by the change of management at the
top. The tussle for supremacy in managing Airbus between
the parent company’s dominant French and German shareholders means that it is currently without a chief executive
at a time when the A380 project is about to enter the crucial phase of flight testing, certification and the build-up of
production before the first delivery in 2006.
Source: Based on Financial Times, 17 January 2005.
Required
Identify the strategic and financial risks in the Airbus
A380 project and suggest how they should be assessed
and managed.
SUMMARY
Risk is an important element in virtually all investment decisions. Because most people in business are risk-averse, the identification, measurement and, where possible,
reduction of risk should be a central feature in the decision-making process. The evidence suggests that firms are increasingly conducting risk analysis. This does not
mean that the risk dimension is totally ignored by other firms; rather, they choose to
handle project risk by less objective methods such as experience, feel or intuition.
We have defined what is meant by risk and examined a variety of ways of measuring it. The probability distribution, giving the probability of occurrence of each possible outcome following an investment decision, is the concept underlying most of the
methods discussed. Measures of risk, such as the standard deviation, indicate the
extent to which actual outcomes are likely to vary from the expected value.
Key points
■
The expected NPV, although useful, does not show the whole picture. We need to
understand managers’ attitudes to risk and to estimate the degree of project risk.
■
Three types of risk are relevant in capital budgeting: project risk in isolation, the
project’s impact on corporate risk and its impact on market risk. The last two are
addressed more fully in the following two chapters.
■
The standard deviation, semi-variance and coefficient of variation each measure, in
slightly different ways, project risk.
■
Sensitivity analysis and scenario analysis are used to locate and assess the potential
impact of risk on project performance. Simulation is a more sophisticated approach,
which captures the essential characteristics of the investment that are subject to
uncertainty.
■
The NPV formula can be adjusted to consider risk. Adjustment of the cash flows
is achieved by the certainty equivalent method. The risk-adjusted discount rate
increases the risk premium for higher-risk projects.
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212 Part III Investment risk and return
Further reading
A fuller treatment of risk is found in Levy and Sarnat (1994). Useful research studies on the use
of risk analysis are given in Pike (1988, 1996), Pike and Ho (1991), Mao and Helliwell (1969) and
Bierman and Hass (1973).
APPENDIX
MULTI-PERIOD CASH FLOWS AND RISK
For simplicity, we have so far assumed single-period investments and conveniently
ignored the fact that investments are typically multi-period. As risk is to be specifically evaluated, cash flows should be discounted at the risk-free rate of interest, reflecting only the time-value of money. To include a risk premium within the discount rate,
when risk is already considered separately, amounts to double-counting and typically
understates the true net present value. The expected NPV of an investment project is
found by summing the present values of the expected net cash flows and deducting
the initial investment outlay. Thus, for a two-year investment proposal:
NPV X2
X1
Io
1i
11 i2 2
where NPV is the expected NPV, X1 is the expected value of net cash flow in Year 1,
X2 is the expected value of net cash flow in Year 2, Io is the cash investment outlay and
i is the risk-free rate of interest.
A major problem in calculating the standard deviation of a project’s NPVs is that
the cash flows in one period are typically dependent, to some degree, on the cash flows
of earlier periods. Assuming for the present that cash flows for our two-period project
are statistically independent, the total variance of the NPV is equal to the discounted
sum of the annual variances.
For example, the Bronson project, with a two-year life, has an initial cost of £500 and
the possible payoffs and probabilities outlined in Table 8.7. Applying the standard
deviation and expected value formulae already discussed, we obtain an expected NPV
of £268 and standard deviation of £206.
Assuming a risk-free discount rate of 10 per cent, the expected NPV is:
NPV Table 8.7
Bronson project payoffs with independent
cash flows
300
600
500 £268
11.102
11.102 2
Probability
Year 1 cash flow (£)
Year 2 cash flow (£)
0.1
0.2
0.4
0.2
0.1
100
200
300
400
500
200
400
600
800
1,000
£300
£109
£600
£219
Expected value
Standard deviation
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Chapter 8 Analysing investment risk
213
The standard deviation of the entire proposal is found by discounting the annual
variances to their present values, applying the equation:
s
s2t
N
a 11 i2 2
B t1
In our simple case, this is:
s
s21
B 11 i2
2
s22
11 i2 4
12,000
48,000
£206
B 11.12 2
11.12 4
The project therefore offers an expected NPV of £268 and a standard deviation of
£206.
■
Perfectly correlated cash flows
At the other extreme from the independence assumption is the assumption that the
cash flows in one year are entirely dependent upon the cash flows achieved in previous periods. When this is the case, successive cash flows are said to be perfectly correlated. Any deviation in one year from forecast directly affects the accuracy of
subsequent forecasts. The effect is that, over time, the standard deviation of the probability distribution of net present values increases. The standard deviation of a stream
of cash flows perfectly correlated over time is:
N
st
s a
11
i2 t
t1
Returning to the example in Table 8.7, but assuming perfect correlation of cash
flows over time, the standard deviation for the project is:
s
£109
£219
1.1
11.12 2
£280
Thus the risk associated with this project is £280, assuming perfect correlation,
which is higher than that for independent cash flows. Obviously, this difference would
be considerably greater for longer-lived projects.
In reality, few projects are either independent or perfectly correlated over time. The
standard deviation lies somewhere between the two. It will be based on the formula
for the independence case, but with an additional term for the covariance between
annual cash flows.
■
Interpreting results
While decision-makers are interested to know the degree of risk associated with a
given project, their fundamental concern is whether the project will produce a positive
net present value. Risk analysis can go some way to answering this question. If a project’s probability distribution of expected NPVs is approximately normal, we can estimate the probability of failing to achieve at least zero NPV. In the previous example,
the expected NPV was £268. This is standardised by dividing it by the standard deviation using the formula:
Z
X NPV
s
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214 Part III Investment risk and return
where X in this case is zero and Z is the number of standardised units. Thus, in the
case of the independent cash flow assumption, we have:
Z
0 £268
£206
1.30 standardised units
Reference to normal distribution tables reveals that there is a 0.0968 probability that
the NPV will be zero or less. Accordingly there must be a 11 0.09682 or 90.32 per cent
probability of the project producing an NPV in excess of zero.
It is probably unnecessary to attempt to measure the standard deviation for every
project. Even the larger European companies tend to use probability analysis sparingly
in capital project analysis. Unless cash flow forecasting is wildly optimistic, or the
future economic conditions underlying all investments are far worse than anticipated,
the bad news from one project should be compensated by good news from another
project.
Sometimes, however, a project is of such great importance that its failure could
threaten the very survival of the business. In such a case, management should be fully
aware of the scale of its exposure to loss and the probability of occurrence.
■
Probability of failure: Microloft Ltd
Microloft Ltd, a local family-controlled company specialising in attic conversions, is
currently considering investing in a major expansion giving wider geographical coverage. The NPV from the project is expected to be £330,000 with a standard deviation
of £300,000. Should the project fail (perhaps because of the reaction by major competitors), the company could afford to lose £210,000 before the bank manager ‘pulled the
plug’ and put in the receiver. What is the probability that this new project could put
Microloft out of business?
We need to find the value of Z where X is the worst NPV outcome that Microloft
could tolerate:
Z
X NPV
s
£210 £330
1.8
£330
Assuming the outcomes are normally distributed, probability tables will show a 3.6
per cent chance of failure from accepting the project. A family-controlled business, like
Microloft, may decide that even this relatively small chance of sending the company
on to the rocks is more important than the attractive returns expected from the project.
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Chapter 8 Analysing investment risk
215
QUESTIONS
Questions with a coloured number have solutions in Appendix B on page 697.
1 Explain the importance of risk in capital budgeting.
2 Explain the distinction between project risk, business risk, financial risk and portfolio risk.
3 The ‘wood pulp’ project has an initial cost of £13,000 and the firm’s risk-free interest rate is 10 per cent. If certainty equivalents and net cash flows (NCF) for the project are as below, should the project be accepted?
Year
1
2
3
4
5
6
7
Certainty equivalents
Net cash flows (£)
0.90
0.85
0.80
0.75
0.70
0.65
0.60
8,000
7,000
7,000
5,000
5,000
5,000
5,000
4 Mystery Enterprises has a proposal costing £800. Using a 10 per cent cost of capital, compute the expected
NPV, standard deviation and coefficient of variation, assuming independent interperiod cash flows.
Probability
0.2
0.3
0.3
0.2
Year 1 net cash flow (£)
Year 2 net cash flow (£)
400
500
600
700
300
400
500
600
5 Mikado plc is considering launching a new product involving capital investment of £180,000. The machine
has a four-year life and no residual value. Sales volumes of 6,000 units are forecast for each of the four years.
The product has a selling price of £60 and a variable cost of £36 per unit. Additional fixed overheads of £50,000
will be incurred. The cost of capital is 12.5 per cent p.a. Present a report to the directors of Mikado plc giving:
(a) the net present values
(b) the percentage amount each variable can deteriorate before the project becomes unacceptable
(c) a sensitivity graph
6 Devonia (Laboratories) Ltd has recently carried out successful clinical trials on a new type of skin cream,
which has been developed to reduce the effects of ageing. Research and development costs in relation to the
new product amount to £160,000. In order to gauge the market potential of the new product, an independent
firm of market research consultants was hired at a cost of £15,000. The market research report submitted by
the consultants indicates that the skin cream is likely to have a product life of four years and could be sold to
retail chemists and large department stores at a price of £20 per 100 ml container. For each of the four years
of the new product’s life sales demand has been estimated as follows:
Number of 100 ml containers sold
11,000
14,000
16,000
Probability of occurrence
0.3
0.6
0.1
If the company decides to launch the new product, production can begin at once. The equipment necessary
to make the product is already owned by the company and originally cost £150,000. At the end of the new
product’s life, it is estimated that the equipment could be sold for £35,000. If the company decides against
Continued
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216 Part III Investment risk and return
launching the new product, the equipment will be sold immediately for £85,000 as it will be of no further use
to the company.
The new skin cream will require two hours’ labour for each 100 ml container produced. The cost of labour
for the new product is £4.00 per hour. Additional workers will have to be recruited to produce the new product. At the end of the product’s life the workers are unlikely to be offered further work with the company and
redundancy costs of £10,000 are expected. The cost of the ingredients for each 100 ml container is £6.00.
Additional overheads arising from the product are expected to be £15,000 p.a.
The new skin cream has attracted the interest of the company’s competitors. If the company decides not to
produce and sell the skin cream, it can sell the patent rights to a major competitor immediately for £125,000.
Devonia (Laboratories) Ltd has a cost of capital of 12 per cent.
Ignore taxation.
Required
(a) Calculate the expected net present value (ENPV) of the new product.
(b) State, with reasons, whether or not Devonia (Laboratories) Ltd should launch the new product.
(c) Discuss the strengths and weaknesses of the expected net present value approach for making investment
decisions.
(Certified Diploma)
7 Plato Pharmaceuticals Ltd has invested £300,000 to date in developing a new type of insect repellent. The
repellent is now ready for production and sale and the marketing director estimates that the product will sell
150,000 bottles per annum over the next five years. The selling price of the insect repellent will be £5 per bottle and the variable costs are estimated to be £3 per bottle. Fixed costs (excluding depreciation) are expected
to be £200,000 per annum. This figure is made up of £160,000 additional fixed costs and £40,000 fixed costs
relating to the existing business which will be apportioned to the new product.
In order to produce the repellent, machinery and equipment costing £520,000 will have to be purchased
immediately. The estimated residual value of this machinery and equipment in five years time is £100,000. The
company calculates depreciation on a straight-line basis.
The company has a cost of capital of 12 per cent. Ignore taxation.
Required
(a) Calculate the net present value of the product.
(b) Undertake sensitivity analysis to show by how much the following factors would have to change before
the product ceased to be worthwhile:
(i) the discount rate
(ii) the initial outlay on machinery and equipment
(iii) the net operating cash flows
(iv) the residual value of the machinery and equipment
(c) Discuss the strengths and weaknesses of sensitivity analysis in dealing with risk and uncertainty.
(d) State, with reasons, whether or not you feel the project should go ahead.
(Certified Diploma)
8 The managing director of Tigwood Ltd believes that a market exists for ‘microbooks’. He has proposed
that the company should market 100 best-selling books on microfiche, which can be read using a special
microfiche reader that is connected to a television screen. A microfiche containing an entire book can be
purchased from a photographic company at 40 per cent of the average production cost of best-selling
paperback books.
The average cost of producing paperback books is estimated at £1.50, and the average selling price of
paperbacks is £3.95 each. Copyright fees of 20 per cent of the average selling price of the paperback books
would be payable to the publishers of the paperbacks plus an initial lump sum that is still being negotiated,
but is expected to be £1.5 million. No tax allowances are available on this lump-sum payment. An agreement
with the publishers would be signed for a period of six years. Additional variable costs of staffing, handling
and marketing are 20p per microfiche, and fixed costs are negligible.
Tigwood Ltd has spent £100,000 on market research, and expects sales to be 1,500,000 units per year at an
initial unit price of £2.
The microfiche reader would be produced and marketed by another company.
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Chapter 8 Analysing investment risk
Tigwood would finance the venture with a bank loan at an interest rate of 16 per cent per year. The company’s money (nominal) cost of equity and real cost of equity are estimated to be 23 per cent p.a. and 12.6 per
cent p.a., respectively. Tigwood’s money weighted average cost of capital and real weighted average cost of
capital are 18 per cent p.a. and 8 per cent p.a., respectively. The risk-free rate of interest is 11 per cent p.a. and
the market return is 17 per cent p.a.
Corporation Tax is at the rate of 35 per cent, payable in the year the profit occurs. All cash flows may be
assumed to be at the year end, unless otherwise stated.
Required
(a) Calculate the expected net present value of the microbooks project.
(b) Explain the reasons for your choice of discount rate in the answer to part (a). Discuss whether this rate is
likely to be the most appropriate to use in the analysis of the proposed project.
(c) (i) Using sensitivity analysis, estimate by what percentage each of the following would have to change
before the project was no longer expected to be viable:
initial outlay
annual contribution
the life of the agreement
the discount rate
(ii) What are the limitations of this sensitivity analysis?
(d) What further information would be useful to help the company decide whether to undertake the microbook project?
(ACCA)
9 The general manager of the nationalised postal service of a small country, Zedland, wishes to introduce a new
service. This service would offer same-day delivery of letters and parcels posted before 10 a.m. within a distance of 150km. The service would require 100 new vans costing $8,000 each and 20 trucks costing $18,000
each. One hundred and eighty new workers would be employed at an average annual wage of $13,000, and
five managers on average annual salaries of $20,000 would be moved from their existing duties, where they
would not be replaced.
Two postal rates are proposed. In the first year of operation letters will cost $0.525 and parcels $5.25. Market
research undertaken at a cost of $50,000 forecasts that demand will average 15,000 letters per working day and
500 parcels per working day during the first year, and 20,000 letters per day and 750 parcels per day thereafter. There is a five-day working week. Annual running and maintenance costs on similar new vans and
trucks are estimated to be $2,000 per van and $4,000 per truck, respectively, in the first year of operation. These
costs will increase by 20 per cent p.a. (excluding the effects of inflation). Vehicles are depreciated over a fiveyear period on a straight-line basis. Depreciation is tax-allowable and the vehicles will have negligible scrap
value at the end of five years. Advertising in Year 1 will cost $500,000 and in Year 2 $250,000. There will be no
advertising after Year 2. Existing premises will be used for the new service, but additional costs of $150,000
per year will be incurred.
All the above cost data are current estimates and exclude any inflation effects. Wage and salary costs and
all other costs are expected to rise because of inflation by approximately 5 per cent p.a. during the five-year
planning horizon of the postal service. The government of Zedland will not permit annual price increases
within nationalised industries to exceed the level of inflation.
Nationalised industries are normally required by the government to earn at least an annual after-tax
return of 5 per cent on average investment and to achieve, on average, at least zero net present value on their
investments.
The new service would be financed half by internally generated funds and half by borrowing on the
capital market at an interest rate of 12 per cent p.a. The opportunity cost of capital for the postal service is
estimated to be 14 per cent p.a. Corporate taxes in Zedland, to which the postal service is subject, are at
the rate of 30 per cent for annual profits of up to $500,000 and 40 per cent for the balance in excess of
$500,000. Tax is payable one year in arrears. All transactions may be assumed to be on a cash basis and to
occur at the end of the year, with the exception of the initial investment, which would be required almost
immediately.
Continued
217
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218 Part III Investment risk and return
Required
(a) Acting as an independent consultant, prepare a report advising whether the new postal service should be
introduced. Include a discussion of other factors that might need to be taken into account before a final
decision was made. State clearly any assumptions that you make.
(b) Monte Carlo simulation has been suggested as a possible method of estimating the net present value of a
project. Briefly assess the advantages and disadvantages of using this technique in investment appraisal.
(ACCA)
Practical assignment
Describe the types of risks associated with investment decisions in a firm known to you. (If necessary, read the
Annual Report of a major company, like BP plc, to familiarise yourself with a company.) Suggest how these risks
should be formally assessed within their investment appraisal process.
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9
Relationships between investments:
portfolio theory
LEX LIVE
FT
Metro and the weather
Diversified investment strategies can be marvellous things.
Suppose you face a choice of
buying shares in a maker of
sunscreen or in a maker of
umbrellas. The textbook
response is to invest in both.
This guarantees a relatively
high return at moderate risk
levels, whatever the weather.
The same logic should apply
to companies, too. Unfortunately, that has not been the
recent experience of investors.
On Friday, Metro, the German
retail conglomerate, joined the
growing list of companies
blaming their lacklustre performance on a rainy European
summer.
Wet weather may indeed
have hit Metro’s food sales.
But the argument would carry
more weight had the very
same Metro a year ago not put
weak department store sales
down to last summer’s heat.
Groups such as Unilever and
Cadbury Schweppes have also
been keen to use the weather
excuse in recent years, freely
invoking the vagaries of the
climate to explain away their
performance.
This might sound like harmless spin, but it contains a real
danger. This is that companies
may actually believe their own
PR and start to overlook structural challenges, such as the
growth of own labels and discount retailers. These affect
both Unilever and – arguably –
Metro. The German retailer’s
weak like-for-like sales growth
partly reflects lacklustre
demand. But it also raises
some doubts about the returns
of its foreign expansion. When
companies diversify, they take
on a huge extra burden of
management. If Metro cannot
even cope with whatever is
thrown at it by the weather
gods, it should reconsider its
foray abroad – and leave the
task of diversifying to
investors.
Source: Financial Times, 29 October 2004.
Learning objectives
This chapter is designed to explore the financial equivalent of the maxim ‘don’t put all your eggs in
one basket’. In particular, it aims:
■
To give the reader an understanding of the rationale behind the diversification decisions of both
shareholders and companies.
■
To illustrate the mechanics of portfolio construction with a user-friendly approach to statistics,
using numerical examples.
■
To explain why optimal portfolio selection is a matter of personal choice.
■
To examine the drawbacks of portfolio analysis as an approach to project appraisal.
A good grasp of the principles of portfolio analysis is an essential underpinning to understanding the
Capital Asset Pricing Model, to be covered in Chapter 10.
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220 Part III Investment risk and return
9.1
INTRODUCTION
This chapter deals with the theory underlying diversification decisions. Diversification
is a strategic device for dealing with risk. Whereas the previous chapter examined
methods of risk analysis that focused on individual projects, here we study how the
financial manager can exploit interrelationships between projects to adjust the riskreturn characteristics of the whole enterprise. In the process, we will show why many
firms develop a wide spread of activities or portfolios. The term ‘portfolio’ is usually
applied to combinations of securities, but we will show that the principles underlying
security portfolio formation can be applied to combinations of any type of asset, including investment projects.
Many firms diffuse their efforts across a range of products, market segments and
customers in order to spread the risks of declining trade and profitability. If a firm can
reduce its reliance on particular products or markets, it can more easily bear the
impact of a major reverse in any single market. However, firms do not reduce their
exposure to the threat of new products or new competitors for entirely negative reasons. Diversification can generate some major strategic advantages: for example, the
wider the spread of activities, the greater the access to star performing sectors of the
economy. Imagine an economy divided into five sectors, with one star-performer each
year whose identity is always random. A company operating in a single sector is likely to miss out in four years out of five. In such a world, it is prudent to have a stake in
every sector by building a portfolio of all five activities.
Diversification is designed to even out the bumps in the time profile of profits and
cash flows. The ideal form of diversification is to engage in activities that behave in
exactly opposite ways. When sales and earnings are relatively low in one area, the
adverse consequences can be offset by participation in a sector where sales and profits are relatively high. With perfect synchronisation, the time profile of overall returns
will describe the pattern shown in Figure 9.1. This shows the returns from two activities: A, which moves in parallel with the economy as a whole; and B, which moves in
an exactly opposite way. The equal and opposite fluctuations in the returns from these
two activities would result in a perfectly level profile for a diversified enterprise comprising both activities. In generally adverse economic conditions, the returns from
activity A, closely following the economy as a whole, will be depressed, but involvement in activity B has an exactly compensating effect. The reverse applies when the
economy is expanding. The returns from B are said to be contra-cyclical, and the
dampening effect on the variability of returns is called a portfolio effect.
For firms planning to diversify, there are two important messages. First, it is not
enough simply to spread your activities. Different activities are subject to different
types of risk, which are not always closely related. For an internationally diversified
Rate of return
Activity A
overall
enterprise
Activity B
Figure 9.1
Equal and offsetting
fluctuations in returns
Time
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Chapter 9 Relationships between investments: portfolio theory
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firm the factors affecting, say, domestic operations may be quite different for these
affecting overseas operations. If changes in these influences are random and relatively uncorrelated, diversification may significantly reduce the variability of company
earnings. Second, to generate an appreciable impact on overall returns, diversification
must usually be substantial in relation to the whole enterprise. Hence, two key messages of portfolio diversification are: look for unrelated activities, and engage in significant
diversification.
9.2
PORTFOLIO ANALYSIS: THE BASIC PRINCIPLES
The theory of diversification was developed by Markowitz (1952). It can be reduced to
the maxim ‘don’t put all your eggs in one basket’. This is a simple motto, but one that
many investors persistently ignore. How often do we read heart-rending stories of
small investors who have lost all their savings in some shady venture or other? Why do
more than 50 per cent of private investors persist in holding a single security in their
investment portfolios? Perhaps they are unaware of the advantages of spreading their
risks, or have not understood the arguments. Perhaps they are not risk-averse or are
simply irrational.* Rational, risk-averse investors appreciate that not all investments
perform well at the same time, that some may never perform well, and that a few may
perform spectacularly well. Since no one can predict which investments will fall into
each category in any one period, it is rational to spread one’s funds over a wide set of
investments.
A simple example will illustrate the remarkable potential benefits of diversification.
■
Achieving a perfect portfolio effect
An investor can undertake one or both of the two investments, Apple and Pear. Apple
has a 50 per cent chance of achieving an 8 per cent return and a 50 per cent chance of
returning 12 per cent. Pear has a 50 per cent chance of generating a return of 6 per cent
and a 50 per cent chance of yielding 14 per cent. The two investments are in sectors of
the economy that move in direct opposition to each other. The investor expects the
return on Apple to be relatively high when that on Pear is relatively low, and vice versa.
What portfolio should the investor hold?
First of all, note that the expected value (EV) of each investment’s return is identical:
Investment Apple: EV 10.5 8%2 10.5 12%2 14% 6% 2 10%
Investment Pear:
EV 10.5 6%2 10.5 14% 2 13% 7%2 10%
At first glance, it may appear that the investor would be indifferent between Apple
and Pear or, indeed, any combination of them. However, there is a wide variety of
possible expected returns according to how the investor ‘weights’ the portfolio.
Moreover, a badly-weighted portfolio can offer wide variations in returns in different
time periods.
For example, when Pear is the star performer, a portfolio comprising 20 per cent of
Apple and 80 per cent of Pear will offer a return of:
Apple
Pear
Portfolio
10.2 8%2 10.8 14%2 11.6% 11.2%2 12.8%
*The real reason is probably that they have applied for shares in a privatisation, or been given shares
in a building society demutualisation!
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222 Part III Investment risk and return
When Apple is the star, the return is only:
10.2 12%2 10.8 6%2 12.4% 4.8%2 7.2%
Although there should be as many good years for Apple as for Pear, resulting over
the long-term in an average return of 10 per cent, in the shorter term, the investor would
be over-exposed to the risk of a series of bad years for Pear. Happily, there is a portfolio which removes this risk entirely.
Consider a portfolio invested two-thirds in Apple and one-third in Pear. When
Apple is the star, the return on the portfolio, Rp, is a weighted average of the returns
from the two components:
Rp 12>3 12%2 11>3 6%2 18% 2%2 10%
Conversely, when Pear is the star, the portfolio offers a return of:
Rp 12>3 8%2 11>3 14%2 15.33% 4.67%2 10%
With this combination, the risk-averse investor cannot go wrong! The portfolio
completely removes variability in returns as there are only two possible states of the
economy. Any rational risk-averse investor should select this combination of Apple
and Pear to eliminate risk for a guaranteed 10 per cent return. Here, the portfolio
effect is perfect, like that shown in Figure 9.1. However, not every investor would
necessarily opt for this particular balanced portfolio. Super-optimists might load
their funds entirely on to Pear, hoping for 14 per cent returns every year. This may
work for a year or two, but the chances of achieving a consistent return of 14 per
cent year after year are very low. The chance of achieving 14 per cent in the first
year is 50 per cent, but the chance of getting 14 per cent in each of the first two years
is 150 per cent2 150 per cent2 25 per cent and so on. Diversification is usually the
safest (and often the most profitable) policy. We will study later in the chapter how
different portfolio weightings affect the overall risk and return.
In this example, the opportunity to eliminate all risk arises from the perfect negative
correlation* between the two investments, but this attractive property can only be
exploited by weighting the portfolio in a particular way.
Regrettably, cases of perfect negative correlation between the returns from securities are rare. Most investment returns exhibit varying degrees of positive correlation,
largely according to how they depend on overall economic trends. This does not rule
out risk-reducing diversification benefits, but suggests they may be less pronounced
than in our example. As we will see, the extent to which portfolio combination can achieve
a reduction in risk depends on the degree of correlation between returns. Later in the chapter, we will examine rather more realistic cases, but first we need to explore more
fully the nature and measurement of portfolio risk.
Self-assessment activity 9.1
What are the two required conditions for total elimination of portfolio risk?
(Answer in Appendix A at the back of the book)
*Readers lacking a grounding in elementary statistics may want to consult an introductory text such
as C. Morris, Quantitative Approaches in Business Studies (Pearson Education), in order to study the concept of correlation. Correlation is measured on a scale of 1 (perfect negative correlation) through zero
to 1 (perfect positive correlation).
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Chapter 9 Relationships between investments: portfolio theory
9.3
223
HOW TO MEASURE PORTFOLIO RISK
We have just seen the importance of the degree of correlation between the returns from
two investments. We saw also how the return from a portfolio could be expressed as a
weighted average of the individual asset returns, the weights being the proportions of
the portfolio accounted for by each of the various components. A similar relationship
applies before the event: that is, if we consider the expected value of the return from the
portfolio. The expected return on a portfolio 1ER p 2 comprising two assets, A and B,
whose individual expected returns are ER A and ER B respectively, is given by:
ER p aER A 11 a2ER B
(9.1)
where a and 11 a2 are the respective weightings of assets A and B, with
a 11 a2 1.
The riskiness of the portfolio expresses the extent to which the actual return may
deviate from the expected return. This may be expressed by the variance of the return,
sp2 , or by its standard deviation, sp.
Portfolio risk
The (rather fearsome!) expression for the standard deviation of a two-asset investment
portfolio, sp, is:
sp 23a2s 2A 11 a2 2s2B 2a11 a2covAB 4
(9.2)
where
a the proportion of the portfolio invested in asset A.
11 a2 the proportion of the portfolio invested in asset B.
s2A the variance of the return on asset A.
s2B the variance of the return on asset B.
covAB the covariance of the returns on A and B.
covariance
A statistical measure of the
extent to which the fluctuations exhibited by two (or
more) variables are related
We need now to explain the meaning of the covariance. The covariance, like the correlation coefficient, is a measure of the interrelationship between random variables, in
this case, the returns from the two investments A and B. In other words, it measures the
extent to which their returns move together, i.e. their co-movement or co-variability.
When the two returns move together, it has a positive value; when they move away from
each other, it has a negative value; and when there is no co-variability at all, its value is
zero. However, unlike the correlation coefficient, whose value is restricted to a scale
ranging from 1 to 1, the covariance can assume any value. It measures co-movement
in absolute terms, whereas the correlation coefficient is a relative measure.
The correlation coefficient between the return on A and the return on B, rAB, is simply the covariance, normalised or standardised, by the product of their standard
deviations:
Correlation coefficient between A and B’s returns rAB covAB
sA sB
The covariance, covAB, between the returns on the two investments, A and B, is
given by:
N
covAB a 3 pi 1RA ER A 2 1RB ER B 2 4
(9.3)
i1
where RA is the realised return from investment A, ER A is the expected value of the
return from A, RB is the realised return from investment B, ER B is the expected value
of the return from B, and pi is the probability of the ith pair of values occurring.
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224 Part III Investment risk and return
Table 9.1
Returns under different
states of the economy
Table 9.2
Calculating the
covariance
State of the economy
E1
E2
E3
E4
RA
10
10
50
50
Probability
Return from A
10%
10%
50%
50%
0.25
0.25
0.25
0.25
ERA
RB
ERB
1R A ERA 2
20
20
20
20
60
20
20
60
20
20
20
20
30
30
30
30
Return from B
60%
20%
20%
60%
1R B ERA 2 Product Probability
40
40
40
40
1200
1200
1200
1200
Weighted
product
300
0.25
300
0.25
300
0.25
300
0.25
covarianceAB 0
Note: Although the rate of return figures are percentages, they have been treated as integers to
clarify exposition.
Equation (9.3) tells us to calculate, for each pair of simultaneously occurring outcomes, their deviations from their respective expected values; next, to multiply these
deviations together and then to weight the resulting product by the relevant probability for each pair. Finally, the sum of all weighted products of paired divergences
between expected and actual outcomes defines the covariance. This relationship is
more easily understood with a numerical example. Table 9.1 shows possible returns
from two assets under four different economic conditions, with associated probabilities. First, do Self-assessment activity 9.2. Then, check through the calculation in
Table 9.2.
Self-assessment activity 9.2
With the figures in Table 9.1, check that the expected values for both A and B are 20 per
cent, and that their respective standard deviations are 30 per cent and 40 per cent, using
the formulae presented in Chapter 8.
(Answer in Appendix A at the back of the book)
In this case, there is no co-variability at all between the returns from the two assets.
If the return from A increases, it is just as likely to be associated with a fall in the
return from B as a concurrent increase. If the covariance (which measures the degree
of co-movement in absolute terms) is zero, we should expect to find the correlation
coefficient (the relative measure of co-movement) is also zero. We may now demonstrate this:
Correlation coefficient
between A and B’s returns rAB covAB
0
0
1sA sB 2
130 402
The case of zero covariance is a very convenient one, as we can see from looking at
the expression for portfolio risk, sp (Equation 9.2 from page 223).
sp 23a2sA2 11 a2 2sB2 2a11 a2covAB 4
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Chapter 9 Relationships between investments: portfolio theory
225
When the covariance is zero, the third term is zero, and portfolio risk reduces to:
sp 23a2sA2 11 a2 2sB2 4
With zero covariance, portfolio risk is thus smaller for any portfolio compared to
cases where the covariance is positive. Even better, when the covariance is negative,
the third term becomes negative and risk falls even further. In general, the lowest
achievable portfolio risk declines as the covariance diminishes: if it is negative, all the
better. There is, however, no limit on the covariance value. If we re-express portfolio
risk in terms of the correlation coefficient, we can be more specific about the greatest
achievable degree of risk reduction. The formula relating covariance and correlation
coefficient (Equation 9.3) can be rewritten as:
covAB 1rAB sA sB 2
Substituting into the expression for portfolio risk (Equation 9.2), we derive:
sp 23a2sA 2 11 a2 2sB 2 2a11 a2rABsA sB 4
Clearly, when the correlation coefficient is negative, risk is reduced, but since the
limit to negative correlation is minus one, this places a lower limit on sp. As we saw
in the Apple and Pear example, this may fall to zero if the portfolio is appropriately
weighted. Whether one works in terms of the covariance or the correlation coefficient
is generally a matter of preference, but, sometimes, it is dictated by the information
available.
■
The optimal portfolio
An obvious question to ask is: which is the best portfolio to hold? In this example, the
two investments have the same expected values, so any portfolio we construct by combining them will also offer this expected value. The optimal portfolio is simply the one
that offers the lowest level of risk. Although very few decision-makers are outright risk
minimisers, any rational risk-averse manager will adopt the risk-minimising action
where every alternative offers an equal expected payoff.
The minimum risk portfolio with two assets
The expression for finding the weighting required to minimise the risk of a portfolio
* the proportion invested in asset A is:
comprising two assets, A and B, where aA
*
aA
sB 2 covAB
sA 2 sB 2 2 covAB
(9.4)
Substituting the figures for the AB example into Equation 9.4, we find:
a*A 1,600
402
0.64
2
2
2,500
30 40
This formula tells us that, to minimise risk, we should place 64 per cent of our funds
in A and 36 per cent in B.
Self-assessment activity 9.3
Verify that the standard deviation of this portfolio is 24%.
(Answer in Appendix A at the back of the book)
In the next section, we analyse the more likely, and more interesting, case where
both the risks and expected returns of the two components differ.
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226 Part III Investment risk and return
9.4
PORTFOLIO ANALYSIS WHERE RISK AND RETURN DIFFER
Suppose we are offered the two investments, Z and Y, whose characteristics are shown
in Table 9.3. Which should we undertake? Or should we undertake some combination?
To answer these questions, we need to consider the possible available combinations of
risk and return. Notice that correlation is negative.
Let us assume that the two assets can be combined in any proportions, i.e. the two
assets are perfectly divisible, as with security investments. There is an infinite number
of possible combinations of risk and return. However, for simplicity, we confine our
attention to the restricted range of portfolios whose risk and return characteristics are
shown in Table 9.4.
Table 9.3
Differing returns and
risks
Asset
Expected return
Standard deviation
15%
35%
20%
40%
Z
Y
Correlation coefficientZY 0.25; Covariancezy 10.252 1202 1402 200
Table 9.4
Portfolio risk–return
combinations (%)
opportunity set
The set of investment opportunities (i.e. risk return combinations) available to the investor
to select from
Z weighting
Y weighting
Expected return
100
75
50
25
0
0
25
50
75
100
15
20
25
30
35
Standard deviation
20
16
20
29
40
If we wanted to minimise risk, we would invest solely in asset Z, since this has the
lowest standard deviation. However, as we move from the all-Z portfolio to the combination 75 per cent of Z plus 25 per cent of Y the risk of the whole portfolio diminishes and the expected return increases. Eventually, though, for portfolios more heavily
weighted towards Y, the effect of Y’s higher risk outweighs the beneficial effect of negative correlation, resulting in rising overall risk.
Figure 9.2 traces the range of available opportunities (or opportunity set), shaped
rather like the nose cone of an aircraft. The profile ranges from point A, representing
total investment in Y, through to point C, representing total investment in Z, having
described a U-turn at B.
Self-assessment activity 9.4
Verify that the portfolio at B, involving 75 per cent of Z and 25 per cent of Y, is the minimum risk combination.
Not all combinations are of interest to the rational risk-averse manager. Comparing
segment AB with the segment BC, we find that combinations lying along the latter are
inefficient. For any combination along BC, we can achieve a higher return for the same
risk by moving to the combination vertically above it on AB. Point S is clearly superior to T and, applying similar logic to the whole of BC, we are left with the segment AB
summarising all efficient portfolios, i.e. those that maximise return for a given risk. AB
is thus called the efficient frontier. Points along AB are said to dominate corresponding points along BC.
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Chapter 9 Relationships between investments: portfolio theory
227
all Y
A
35
Q
S
AB = Efficient frontier
AC = Opportunity set
ERp
P
20
B 75% Z
25% Y
all Z
T
15
C
Figure 9.2
Available portfolio
risk–return combinations when assets, risks
and expected returns
are different
optimal portfolio
The risk–return combination
that offers maximum satisfaction to the investor, i.e. his/her
most-preferred risk-return
combination
16
20
sp
40
However, we cannot specify an optimal portfolio, except for the outright riskminimiser, who would select the portfolio at B, and for the maximiser of expected
return, who would settle at point A (all Y). A risk-averse person might select any
portfolio along AB, depending on his or her degree of risk aversion: that is, what
additional return they would require to compensate for a specified increase in risk.
For example, a highly risk-averse person might locate at point P, while the less cautious person might locate at point Q.
This is a crucial result. The most desirable combination of risky assets depends on the
decision-maker’s attitude towards risk. If we know the extent of their risk-aversion –
that is, how large a premium is required for a given increase in risk – we can specify the
best portfolio.
Self-assessment activity 9.5
What is meant by an efficient frontier in portfolio analysis?
(Answer in Appendix A at the back of the book)
9.5
DIFFERENT DEGREES OF CORRELATION
Using arbitrary values for the correlation coefficient, we have found that negative correlation offers a handsome portfolio effect, and, to a lesser degree, also zero correlation.
It is useful now to consider more carefully the general relationship between risk, correlation and return. To do this, we look at the full range of possible degrees of correlation,
extending from perfect negative to perfect positive.
Say we are dealing with two investments, A and B, with Asset A offering the higher
expected return but also carrying greater risk. These are shown in Figure 9.3.
Consider the following degrees of correlation:
1 Perfect positive. In this case, it is not possible to achieve a portfolio effect at all.
Combinations of A and B locate along the straight line AB. To achieve lower risk
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228 Part III Investment risk and return
A
Expected return on portfolio (ERP)
Perfect negative
correlation
ing
Add
X
B to
A
The pull
of reducing
correlation
Too
mu
ch
B
Perfect positive
correlation
B
Figure 9.3
The effect on the
efficiency frontier of
changing correlation
0
Risk of portfolio
(Standard deviation, sp)
levels, we would simply invest more in asset B, while the risk-minimising ‘portfolio’ is simply asset B alone.
2 Perfect negative. With the returns from the two assets moving in perfect opposition
to each other, it is possible to eliminate risk by adding B to A, but only by weighting the portfolio correctly is it possible to fully exploit the beneficial effect of correlation. Maximum risk-reduction is achieved at point X where the portfolio risk is
zero. Combinations along XB are clearly inefficient.
3 Intermediate values. For correlation coefficients between 1 and 1, it is still possible to generate a portfolio effect. The lower the correlation, i.e. the further away
from 1, the greater the portfolio effect achievable. Two examples are shown in
Figure 9.3 as dotted lines between A and B. The characteristic ‘bow’ shapes result
from progressively lower correlation bending the profile from its original position
until we start observing the ‘nose cones’ identified earlier.
9.6
WORKED EXAMPLE: GERRYBILD PLC
Gerrybild plc is a firm of speculative housebuilders that builds in advance of firm
orders from customers. It has a given amount of capital to purchase land and raw
materials and to pay labour for development purposes. It is considering two design
types – a small two-bedroomed terraced town house and a large four-bedroomed
‘executive’ residence. The project could last a number of years and its success depends
largely on general economic conditions, which will influence the demand for new
houses. Some information is available on past sales patterns of similar properties in
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Chapter 9 Relationships between investments: portfolio theory
Table 9.5
Returns from Gerrybild
229
Estimated NPV £ per:
State of the economy
Probability
Large house
Small house
E1
E2
E3
E4
0.2
0.3
0.4
0.1
2,000
2,000
4,000
4,000
2,000
3,000
2,000
3,000
roughly similar locations – the demand is relatively higher for larger properties in
buoyant economic conditions and for smaller properties in relatively depressed states
of the economy. Since there appears to be a degree of inverse correlation between
demand, and, therefore, net cash flows, from the two products, it seems sensible to
consider diversified development. Table 9.5 shows annual net present value estimates
for various economic conditions.
To analyse this decision problem, we need, first, to calculate the risk–return parameters of the investment, and, second, to assess the degree of correlation. This information may be obtained by performing a number of statistical operations:
1 Calculation of expected values. A shortcut is available, since some outcomes may occur
under more than one state of the economy. Grouping data where possible:
EVL Expected value of a large house 10.5 £2,0002 10.5 £4,0002
£3,000
EVS Expected value of a small house 10.6 £2,0002 10.4 £3,0002
£2,400
2 Calculation of project risks. We now apply the usual expression for the standard deviation. The calculations for each activity are shown in Table 9.6. Clearly, the relative
money-spinner, the large house project, is also the more risky activity.
3 Calculation of co-variability. Table 9.7 presents the calculation of the covariance in tabular form, following the steps itemised in Section 9.3.
Table 9.6
Calculation of standard
deviations of returns
from each investment
Outcome (£)
Probability
EV (£)
Large houses
2,000
4,000
0.5
0.5
3,000
3,000
Deviation
Squared
Weighted squared
(£)
deviation (£)
deviation (£)
1,000
1,000
1,000,000
500,000
1,000,000
500,000
s2L Variance 1,000,000
hence sL 21,000,000
1,000
Small houses
2,000
3,000
0.6
0.4
2,400
2,400
400
600
160,000
96,000
360,000
144,000
s2S Variance 240,000
hence sS 2240,000
489
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230 Part III Investment risk and return
Table 9.7
Calculation of the
covariance
Outcomes (£)
RL
RS Probability
2,000
2,000
4,000
4,000
2,000
3,000
2,000
3,000
1EVL RL 2 (£)
1EVS RS 2 (£)
1,000
1,000
1,000
1,000
400
600
400
600
0.2
0.3
0.4
0.1
Weighted
Product (£) product (£)
400,000
80,000
600,000
180,000
400,000
160,000
60,000
600,000
covLS 200,000
The covariance of £200,000 suggests a strong element of inverse association. This
is confirmed by the value of the correlation coefficient:
rLS covLS
200,000
0.41
sL sS
11,0002 14892
There are clearly significant portfolio benefits to exploit. To offer concrete advice to
the builder, we would require information on his risk–return preferences, but we can
still specify the available set of portfolio combinations. Rather than compute the full
set of opportunities, we will identify the minimum risk portfolio, to enable construction of the overall risk–return profile.
■
The minimum risk portfolio
Using Equation (9.4), and defining a*L as the proportion of the portfolio (i.e. proportion
of the available capital) devoted to large houses to minimise risk, we have:
aL* 1s2S
1s2S covLS 2
s2L
2 covLS 2
240,000 200,000
240,000 1,000,000 400,000
440,000
0.27
1,640,000
If Gerrybild wanted to minimise risk, it would have to invest 27 per cent of its capital in developing large houses and 73 per cent in developing small houses.
Self-assessment activity 9.6
Verify that the lowest achievable portfolio standard deviation is £349 and the expected
NPV per house built from the minimum risk portfolio is £2,562.
(Answer in Appendix A at the back of the book)
■
The opportunity set
We now have assembled sufficient information to display the full range of opportunities available to Gerrybild. The opportunity set ABC is shown on Figure 9.4 as the familiar nose cone shape. If Gerrybild risk-averts, only segment AB is of interest, but
precisely where along this segment it will choose to locate depends the attitude towards
risk of its decision-makers.
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Chapter 9 Relationships between investments: portfolio theory
231
100% large
A
Expected NPV (£)
3,000
2,562
B
C
2,400
100% small
Figure 9.4
Gerrybild’s opportunity
set
349
489
1,000
Risk (standard deviation, £)
Self-assessment activity 9.7
Using Figure 9.4, distinguish between risk minimisation and risk aversion.
(Answer in Appendix A at the back of the book)
9.7
PORTFOLIOS WITH MORE THAN TWO COMPONENTS
Having so far looked only at simple two-asset portfolios, it is now useful to extend the
analysis to more comprehensive combinations (see Figure 9.5). Imagine three assets are
available, A, B and C, for each of which we have estimates of expected return and standard deviation, and also the covariance (and hence correlation) between each pair of
assets. Imagine further that, whereas A and B are quite closely correlated, B and C are
less so, and that correlation between A and C is even weaker.
Using a technique called Quadratic Programming, developed by Sharpe (1963), we
can specify all available portfolios comprising one, two or three assets. Although there
are only seven possible combinations of whole investments (A, B and C alone, A plus
B, B plus C, A plus C and all three together), there are myriad combinations if we allow
for divisibility of assets. The full range of available portfolios, i.e. risk–return combinations, is shown by the opportunity set in the form of an envelope, or ‘bat-wing’.
The corners represent individual assets, while two-asset combinations are shown
by the solid lines AB and BC and the dotted profile AC. Notice that by combining A
and C, the investor can exploit their relative lack of correlation by accessing relatively
more attractive portfolios in terms of their respective returns for particular levels of
risk. The opportunity set thus moves inwards as assets with lower correlation are
included. However, he can now access even more attractive combinations of A and C
by combining all three assets. Points inside the envelope, or along the outer boundary,
represent all possible combinations of A, B and C.
Notice that the investor now has access to a far wider range of investment combinations. If he is limited to combinations of only two assets, say A and B, as we saw in
earlier analyses, he is restricted to risk–return combinations along AB or BC, depending on which two assets are combined. However, if access is opened up to include a
third asset, the expanded range of combinations now available allows him to select far
superior mixes of risk and return. For example, combinations within the envelope and
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232 Part III Investment risk and return
A, B and C combined
A and C combined
Expected return on portfolio (ERP)
A
Figure 9.5
Portfolio combinations
with three assets
A and
B combined
B
E
B and C combined
C
A and C
combined
Risk of portfolio
(Standard deviation, sp)
on its upper bound, AEC, are superior to most of the two-asset portfolios available
along AB and BC.
As before, we can differentiate between efficient and inefficient combinations.
Clearly, all points lying beneath the upper edge AE and those along the segment EC are
inefficient. The efficient set is therefore AE, identical in shape to our earlier profile,
except that we are dealing with three-asset combinations (enabling investors to achieve
lower levels of risk for specified returns by diversifying away yet more risk). Similar
principles would apply if we were dealing with 30 or 300 assets, although the information requirements would become progressively more formidable.
Generally, we can conclude that the more assets that are available, the wider the
range of choice open to the investor, and the greater his opportunities to achieve more
desirable combinations of risk and return. The more assets under consideration, the
nearer to the vertical axis lies the envelope of portfolios. Hence, the higher is the return
achievable for a given risk, or conversely, the lower is the risk achievable for a specified expected return.
Notice also that the earlier conclusion about the optimal portfolio remains valid – it
still depends on the particular investor’s risk–return preferences.
Self-assessment activity 9.8
Draw an envelope of portfolios for the case where four assets are available to invest in,
either individually or as portfolios.
(Answer in Appendix A at the back of the book)
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Chapter 9 Relationships between investments: portfolio theory
9.8
233
CAN WE USE THIS FOR PROJECT APPRAISAL? SOME RESERVATIONS
The Gerrybild example illustrates some drawbacks with the portfolio approach to handling project risk.
1 Most projects can be undertaken only in a very restricted range of sizes or even on
an ‘all-or-nothing’ basis. This does not entirely undermine the portfolio approach –
it simply means that the range of combinations available is much narrower.
Besides, enterprises are often undertaken on a joint venture basis (e.g. in large,
high-risk activities like Eurotunnel and Airbus and many cross-border automobile
operations), where the various parties have some freedom to select the extent of
their participation.
2 A more severe problem is the implication of constant returns to scale. Our analyses imply that if a smaller version of a project is undertaken, the percentage
returns, or the absolute return per pound invested, will remain unchanged. For
example, if the return on a whole project is 20 per cent, the return from doing 30
per cent of the same project is still 20 per cent. This may apply for investment in
securities, but is unlikely for investment projects, where there is often a minimum
size below which there are zero or negative returns, and, thereafter, increasing
returns to scale.
3 We should be wary of any approach that relies on subjective assessments of probabilities, or at least wary of the probabilities themselves. In the case of repetitive
activities, such as replacement of equipment, about which a substantial data bank
of costs and benefits has been compiled, the probabilities may have some basis in
reality. In other cases, such as major new product developments, probabilities are
largely based on inspired guesswork. Different decision analysts may well formulate different ‘guesstimates’ about the chances of particular events occurring.
However, the subjective nature of probabilities used in practice need not be a deterrent if the estimates are well supported by reasoned argument, and therefore instil
confidence.
4 Since attitudes to risk determine choice, we need to know the decision-maker’s utility function, which summarises his or her preferences for different monetary amounts.
The difficulties of obtaining information about an individual manager’s utility
function (let alone for a group) are formidable, as Swalm (1966) has shown. Besides,
we should really be seeking to apply the risk-return preferences of shareholders
rather than those of managers.
5 The portfolio approach to analysing project risk seems unduly management-oriented.
Managers formulate the assessments of alternative payoffs, assess the relevant
probabilities and determine what combinations of activities the enterprise should
undertake. Managers are considerably less mobile and less well diversified than
shareholders, who can buy and sell securities more or less at will. Managers can
hardly shrug off a poor investment outcome if it jeopardises the future of the enterprise or, more pertinently, their job security. Most managers are more risk-averse
than shareholders, resulting in the likelihood of sub-optimal investment decisions.
Here, we see another manifestation of the agency problem – how do we get managers to accept the levels of risk that owners are prepared to tolerate?
These may appear to be highly damaging criticisms of the portfolio approach, especially as it applies to investment decisions. However, although having limited operaCapital Asset Pricing Model tional usefulness for many investment projects, it provides the infrastructure of a more
The CAPM is a model designed
sophisticated approach to investment decision-making under risk, the Capital Asset
to explain how the stock market values capital assets, includ- Pricing Model (CAPM). This is based on an examination of the risk–return characterising ordinary shares by assessing
tics and resulting portfolio opportunities of securities, rather than physical investment
their relative risk-return
properties
opportunities.
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234 Part III Investment risk and return
The CAPM explains how individual securities are valued, or priced, in efficient capital markets. Essentially, this involves discounting the future expected returns from holding a security at
a rate that adequately reflects the degree of risk incurred in holding that security. A major contribution of the CAPM is the determination of the premium for risk demanded by the
market from different securities. This provides a clue as to the appropriate discount rate
to apply when evaluating risky projects. The CAPM is analysed in the next chapter.
SUMMARY
This chapter has examined some reasons why firms diversify their activities, and has
considered the extent to which the theory of portfolio analysis can provide operational
guidelines for diversification decisions.
Key points
■
Both firms and individuals diversify investments – firms build portfolios of business activities and individuals build portfolios of securities.
■
An important motive for business diversification is to reduce fluctuations in returns.
■
Variations in returns can be totally eliminated only if the investments concerned
have perfect negative correlation and if the portfolio is weighted so as to minimise
risk.
■
The expected return from a portfolio is a weighted average of the returns expected from its components, the weights being determined by the proportion of capital invested in each activity or security. For a portfolio comprising the two assets,
A and B:
ER p aER A 11 a2ER B
■
Portfolio risk, however, is given by a square-root formula:
sp 23a2sA2 11 a2 2sB2 2a11 a2covAB 4
■
The degree of covariability between the returns expected from the components of
the portfolios can be measured by the covariance, covAB, or by the correlation coefficient, rAB. The lower the degree of covariability, the lower is the risk of the portfolio (for given weightings).
■
The available risk–return combinations for mixing investments are shown by the
opportunity set.
■
Some combinations can be rejected as inefficient. Rational risk-averting investors
focus only on the efficient set.
■
The optimal portfolio for any investor depends on their attitude to risk: that is, how
risk-averse they are.
■
In practice, there are serious difficulties in applying the portfolio techniques to
physical investment decisions.
Further reading
The classic works on portfolio theory are by Markowitz (1952), Sharpe (1964) and Tobin (1958)
(all of whom have won Nobel Prizes for Economics). See also Fama and Miller (1972), Sharpe,
Alexander and Bailey (1996), Levy and Sarnat (1994) and Copeland and Weston (2004) for more
developed analyses, and also proofs and derivations of the formulae used in this chapter. Finally,
Markowitz’s Nobel address (1991) is well worth reading.
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Chapter 9 Relationships between investments: portfolio theory
QUESTIONS
Questions with a coloured numbers have solutions in Appendix B on page 697.
1 The returns on investment in two projects, X and Y, have standard deviations of 30 per cent and 45 per cent
respectively. The correlation coefficient between the returns on the two investments is 0.2. What is the standard deviation of a portfolio containing equal proportions of the two investments?
2 Determine the risk-minimising portfolios for the following two asset portfolios.
(i)
ER A 8%; ER B 10%; sA 3%; sB 7%; rAB 1
(ii)
ER A 20%; ER B 12%; sA 12%; sB 6%; rAB 12
(iii) ER A 11%; ER B 5%; sA 15%; sB 1%; rAB 12
(iv) ER A 11%; ER B 5%; sA 15%; sB 1%; rAB 0
3 Tomb-zapper plc manufactures computer video games. It is considering whether to expand production at its
existing site in ‘Silicon Glen’ in Scotland, or to start production in a ‘greenfield site’ in China, where labour
costs are considerably lower than in Europe. The IRRs for each project depend on average rates of growth in
the world economy over the ten-year life span of the project. These are expected to be:
World growth
Probability
Rapid
Stable
Slow
0.3
0.4
0.3
IRR China
IRR Scotland
50%
25%
0%
10%
15%
16%
Tomb-zapper wants to exploit the less than perfect correlation between the returns from the two projects,
without over-committing itself to the China investment.
Required
(a) What is the expected return and standard deviation of return for each separate project?
(b) Determine the expected return and standard deviation of an expansion programme that involves 25 per
cent of available funds in China and 75 per cent in the Scottish location.
4 Nissota, a Japanese-based car manufacturer, is evaluating two overseas locations for a proposed expansion of
production facilities at a site in Ireland and another on Humberside. The likely future return from investment
in each site depends to a great extent on future economic conditions. Three scenarios are postulated, and the
internal rate of return from each investment is computed under each scenario. The returns with their estimated probabilities are shown below:
Probability
0.3
0.3
0.4
Internal rate of return (%)
Ireland
Humberside
20
10
15
10
30
20
There is zero correlation between the returns from the two sites.
Required
(a) Calculate the expected value of the IRR and the standard deviation of the return from investment in each
location.
(b) What would be the expected return and the standard deviation of the following split investment strategies:
(i) committing 50 per cent of available funds to the site in Ireland and 50 per cent to Humberside?
(ii) committing 75 per cent of funds to the site in Ireland and 25 per cent to the Humberside site?
235
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236 Part III Investment risk and return
5 The management of Gawain plc is evaluating two projects whose returns depend on the future state of the
economy as shown below:
Probability
IRRA (%)
IRRB (%)
0.3
0.4
0.3
27
18
5
35
15
20
The project (or projects) accepted would double the size of Gawain.
Required
(a) Explain how a portfolio should be constructed to produce an expected return of 20 per cent.
(b) Calculate the correlation between projects A and B, and assess the degree of risk of the portfolio in (a).
(c) Gawain’s existing activities have a standard deviation of 10 per cent. How does the addition of the portfolio analysed in (a) and (b) affect risk?
Practical assignment
Select a company with a reasonably wide portfolio of activities. Such companies do not always give segmental
earnings figures, but they usually divulge sales figures for their component activities. By looking at the annual
reports for three or four years, you can obtain a series of annual sales figures for each activity.
Assess the degree of past volatility of the sales of each sub-unit and their degree of inter-correlation. Also, see
whether you can assess the extent of the correlation between each segment and the overall enterprise. How well
diversified does your selected company appear to be? What qualifications should you make in your analysis?
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10
Setting the risk premium: the Capital Asset
Pricing Model
Target practice does not make perfect
Efficient capital markets should generate an upwardsloping risk-return frontier on which all securities
locate – the higher the risk, the higher the required
return. The Capital Asset Pricing Model (CAPM) explains
how great a premium is required for specified risks.
Although companies acknowledge the need to discount
returns expected from risky activities at higher rates,
surveys conducted by the Confederation of British
Industry (CBI) reveal some alarming information about
how firms approach capital investment decisions.
In 1998, the CBI surveyed 326 firms with turnovers
above £20 million and with capital expenditures ranging from rather less than £1 million to well over
£25 million. Two points stood out:
1 Firms tended to apply much higher rates than
appear warranted by theoretical best practice, with
those using IRR setting higher hurdle rates than
users of the NPV method.
2 Firms tend not to adjust their hurdle rates when
inflation rates change. Only 60 per cent of respondents conducted a regular review of hurdle rates, and
there was little evidence that targets had fallen since
the previous study in 1994, despite lower inflation.
Setting too high a cut-off rate for investment projects carries two dangers. First, it may curtail the volume
of capital expenditure to the detriment of business
growth. Second, setting too high a target may lead to
over-investment in high risk, speculative projects
(albeit potentially lucrative ones) at the expense of
more secure ‘bread and butter’ capital projects.
Source: Target Practice, Confederation of British Industry, 1998.
Learning objectives
This chapter deals with the rate of return required by shareholders of an all-equity financed company, building on portfolio theory. Its specific aims are:
■
To explain what type of risk is relevant for valuing capital assets.
■
To explain what a ‘Beta coefficient’ is.
■
To determine the appropriate risk premium to incorporate into a discount rate, whether for
investment in securities or in capital projects.
■
To examine the case for corporate diversification.
■
To examine some criticisms of the CAPM.
An understanding of the significance of Beta coefficients is particularly important in appreciating
how financial managers should view risk.
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238 Part III Investment risk and return
10.1
INTRODUCTION
In Chapters 8 and 9, we examined various methods of handling risk and uncertainty in
project appraisal, ranging from sensitivity analysis to diversification to exploit the less
than perfect correlation between the returns from risky investments. Most of these
approaches aim to identify the sources and extent of project risk and to assess whether
the expected returns sufficiently compensate investors for bearing the risk. Utility theory suggests that, as risk increases, rational risk-averse people require higher returns,
justifying the common practice of adjusting discount rates for risk. However, none of
these approaches offers an explicit guide to measuring the precise reward investors
should seek for incurring a particular level of risk.
The CAPM is a theory originally devised by Sharpe (1964) to explain how the capital market sets share prices. It now provides the infrastructure of much of modern
financial theory and research and offers important insights into measuring risk and
setting risk premiums. In particular, it shows how the study of security prices can help
in assessing required rates of return on investment projects. However, as we shall see,
the CAPM has not gone unchallenged.
10.2
SECURITY VALUATION AND DISCOUNT RATES
Asset value is governed by two factors – the stream of expected benefits from holding
the asset and their ‘quality’, or likely variability. For example, the value of a singleproject company is assessed by discounting future project cash flows at a discount rate
reflecting their risk. The value, Vo, of a company newly formed by issuing one million
shares to exploit a one-year project offering a single net cash flow of £10 million, at a
25 per cent discount rate, is:
Vo £10 m
£8 m
11.252
This suggests a market price per share of 1£8 m>1 m shares2 £8. This would be the
value established by an efficient capital market taking account of all known information about the company’s future prospects.
Sometimes, the ‘correct’ discount rate is unclear to the firm. A major contribution of
the CAPM is to explain how discount rates are established and hence how securities
are valued. However, from the capital market value of a company, we can ‘work backwards’ to infer what discount rate underlies the market price. In the example, if we
observe a market price of £8 this suggests a required return of 25 per cent.
By implication, if the market sets a value on a security that implies a particular discount rate, it is reasonable to conclude that any further activity of similar risk to current
operations should offer at least the same rate. This argument depends critically on
market prices being unbiased indicators of the intrinsic worth of companies, i.e. that
the Efficient Markets Hypothesis applies.
Any discount rate is an amalgam of three components:
1 Allowance for the time value of money – the compensation required by investors
for having to wait for their payments.
2 Allowance for price level changes – the additional return required to compensate
for the impact of inflation on the real value of capital.
3 Allowance for risk – the promised reward that provides the incentive for investors
to expose their capital to risk.
Ignoring expected inflation (or assuming that it is ‘correctly’ built into the structure
of interest rates), discount rates have two components – the rate of return required on
totally risk-free assets, such as government securities, and a risk premium.
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Chapter 10 Setting the risk premium: the Capital Asset Pricing Model
10.3
239
CONCEPTS OF RISK AND RETURN
In this section, we examine risk and return concepts relevant for security valuation.
■
The returns from holding shares
Investors hold securities because they hope for positive returns. Purchasers of ordinary
shares are attracted by two elements: first, the anticipated dividend(s) payable during
the holding period; and second, the expected capital gain. Taken together, these elements make up the Total Shareholder Return (TSR).
Total Shareholder Return (TSR)
In general, for any holding period, t, and company, j, the TSR is the percentage return,
Rjt, from holding its shares:
Rjt Djt 1Pjt Pjt1 2
Pjt1
100
where Djt is the dividend per share paid by company j in period t, Pjt is the share price
for company j at the end of period t and Pjt1 is the share price for company j at the start
of period t.
To illustrate this calculation (and to show that returns are not always positive!), consider the following figures for the UK-based glass-making firm Pilkington plc for
2003–4:
Share price at end of March 2003 49p
Share price at end of March 2004 89p
Net dividend paid during 2003–4 5p per share
The percentage return over this year was:
5p 189p 49p2
49p
100 45p
49p
100 91.8%
Table 10.1 shows the annual returns and how they varied for the decade 1994–2004.
If we regard past returns on Pilkington shares as a good guide to likely future
returns and also believe that future annual returns will be randomly distributed about
the mean, we might assess the expected value of holding Pilkington shares for a given
year as 4.8 per cent. However, the actual return in any one year may diverge considerably from this average, as indicated by the substantial standard deviation. The variability in return would suggest that investors should seek a high return to compensate
for this risk. However, not all risk is relevant in setting the required return. We will see
why in the next section.
Table 10.1
The annual TSRs on
Pilkington shares
Year
1994–5
1995–6
1996–7
1997–8
1998–9
Return (%)
Year
8.1
30.5
40.2
6.7
28.3
1999–00
2000–1
2001–2
2002–3
2003–4
Arithmetic mean*
Standard deviation
Return (%)
5.5
52.1
10.4
61.0
91.8
4.8%
42.7%
*Note: Strictly, the geometric mean should be used here as we are
dealing with proportions.
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240 Part III Investment risk and return
Figure 10.1 Total Shareholder Return (TSR) 5-year graph 1999–2004 (Covering the period from 1st April 1999
to 31st March 2004)
TSR (re-based to 1st April 1999)
250
200
Pilkington
150
FTSE 250 Index
100
3-month moving average
50
March 1999
March 2000
March 2001
March 2002
March 2003
March 2004
Financial years ended
Source: Pilkington plc, Annual Report and Accounts 2004.
However, before this it is useful to examine an alternative and, arguably, more
meaningful measure of shareholder return. Instead of looking at annual rates of
return, we might look at the overall return over a particular period, and then convert
this into an annual equivalent rate of return. Indeed, this is the measure of TSR most
commonly used in practice. The Pilkington plc 2004 Annual Report showed its TSR
over the period March 1999–March 2004, reflecting share price movements, and
assuming re-investment of dividends. This is shown in Figure 10.1. Starting from a
base of 100, the value of the shareholders’ investment rose to 211.5, equivalent to an
annual average rate of return of about 16 per cent.
Self-assessment activity 10.1
Determine the TSR for the year 200X in the following case:
■
Share price January 1st: £2.20
Share price December 31st: £2.37
■ Interim dividend paid: £0.035 per share
■ Final dividend paid: £0.065 per share
■
(Answer in Appendix A at the back of the book)
■
The risks of holding ordinary shares
In Chapter 9, we saw the power of portfolio combination in reducing the risk of a collection of investments. Risk was measured by the variance or standard deviation of the
return on the combination. This measure can also be applied to portfolios of securities,
with some remarkable results, as shown in Figure 10.2.
As the number of securities held in the portfolio increases, the overall variability of
the portfolio’s return, measured by its standard deviation, diminishes very sharply for
small portfolios, but falls more gradually for larger combinations. This reduction is
achieved because exposure to the risk of volatile securities can be offset by the inclusion of low-risk securities or even ones of higher risk, so long as their returns are not
closely correlated.
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Risk of portfolio
(Standard deviation of return)
Chapter 10 Setting the risk premium: the Capital Asset Pricing Model
241
Total risk
Specific
risk
Market
risk
Figure 10.2
Specific vs. market risk
of a portfolio
■
0
Number of securities in portfolio
Specific and systematic risk
Not all the risk of individual securities is relevant for assessing the risk of a portfolio of
risky shares. The total risk of securities (and also of portfolios) has two components:
1 Specific risk: the variability in return due to factors unique to the individual firm.
2 Systematic risk: the variability in return due to dependence on factors that influence
the return on all securities traded in the market.
Specific risk refers to the expected impact on sales and earnings of random events –
industrial relations problems, equipment failure, R&D achievements etc. In a portfolio
of shares, such factors tend to cancel out as the number of securities included increases.
Systematic risk refers to the impact of movements in the macroeconomy, such as
fiscal changes, swings in exchange rates and interest rate movements, all of which
cause reactions in security markets. These are captured in the movement of an index
reflecting security prices in general, such as the FTSE in the UK or the DAX index in
Germany. No firm is entirely insulated from these factors, and even portfolio diversification cannot provide total protection. Because these factors affect all firms in the
market, such risk is often called ‘market-related’ (or just ‘market’) risk.
Returning to Figure 10.2, we see that the reduction in the total risk of a portfolio is
achieved by gradual elimination of the risks unique to individual companies, leaving
an irreducible, undiversifiable, risk floor. The extent to which specific risk declines for
a portfolio comprising N equally-weighted and randomly-selected securities is also
shown in Table 10.2.
Substantial reductions in specific risk can be achieved with quite small portfolios,
and the main scope for risk reduction is achieved with a portfolio of around 30 securities. To eliminate unique risk totally would involve holding a vast portfolio comprising
all the securities traded in the market. This construct, called the ‘market portfolio’, has
a pivotal role in the CAPM, but for the individual investor, it is neither practicable nor
cost-effective, in view of the dealing fees required to construct and manage it. However,
since relatively small portfolios can capture the lion’s share of diversification benefits,
it is only a minor simplification to use a well-diversified portfolio as a proxy for the
overall market, such as the FTSE-100, which covers approximately 80 per cent of the
market capitalisation of all UK quoted companies (www.ftse.com).
Self-assessment activity 10.2
How many shares would an investor have to hold in order to totally eliminate specific risk?
(Answer in Appendix A at the back of the book)
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242 Part III Investment risk and return
Table 10.2
How to remove
portfolio risk
Number of
securities (N)
1
2
4
8
16
32
64
500
Reduction in
specific risk (%)
0
46
72
81
93
96
98
99
Source: Fosback (1985).
■
Implications
Three major implications now follow:
1 It is clear that risk-averse investors should diversify. Yet in reality, over half of UK
investors hold just one security (usually, shares in a privatised company or a former
building society). However, the major players in capital markets, holding well over
60 per cent of all quoted UK ordinary shares, are financial institutions such as pension funds and insurance companies, which do hold highly diversified portfolios.
2 Investors should not expect rewards for bearing specific risk. Since risk unique to particular companies can be diversified away, the only relevant consideration in assessing risk premiums is the risk that cannot be dispersed by portfolio formation. If
bearing unique risk was rewarded, astute investors prepared to build portfolios
would snap up securities with high levels of unique risk to diversify it away, while
still hoping to enjoy disproportionate returns. The value of such securities would
rise and the returns on them would fall until only systematic risks were rewarded.
3 Securities have varying degrees of systematic risk. Few securities exhibit patterns of
returns rising or falling exactly in line with the overall market. This is partly because
in the short term, unique random factors affect particular companies in different
ways. Yet even in the long term, when such factors tend to even out, very few securities track the market. Some appear to outperform the market by offering superior
returns and some appear to underperform it. However, performance relative to the
market should not be too hastily judged, because the returns on different securities
do not always depend on general economic factors in the same way.
For example, in an expanding economy, retail sales tend to increase sharply, but
sales in less responsive sectors like water and defence are barely altered. Share
prices of retailers usually increase quite sharply in an expanding economy, but the
share prices of water companies and armaments suppliers respond far less dramatically. Retail sales are said to be ‘more highly geared to the economy’. Systematic or
market risk varies between companies, so we find different companies valued by
the market at different discount rates. Already, we begin to see that the CAPM,
based on the premise that rational investors can and do hold efficiently diversified
portfolios, may show us how these discount rates might be assessed. Clearly, we
need to measure systematic risk. This is covered in Section 10.5.
Self-assessment activity 10.3
Give three examples of systematic and unique factors that cause the returns on holding
ordinary shares to vary over time.
(Answer in Appendix A at the back of the book)
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10.4
243
THE RELATIONSHIP BETWEEN DIFFERENT EQUITY MARKETS
Investors have tended to prefer to invest in their own national stock markets, although
this is changing. Reasons for this past parochialism include:
■
■
■
■
■
relative lack of research into overseas markets and firms
transactions costs, especially connected with foreign exchange
fear of foreign exchange risk
legal barriers, e.g. custody regulations
political risk.
Total risk of portfolio
(Standard deviation of return)
Several studies have shown that international diversification can generate even greater
portfolio benefits than investing in purely domestic shares. Recall that the reason that
portfolio risk reduces as the number of component shares increases was low correlation
between investments, enabling investors to reduce specific risks. However, if foreign
stock markets are less than perfectly correlated, it may be possible to lower risk below
the level of market risk that defines the floor of the risk profile relating to purely domestic investment.
Indeed, studies pioneered by Solnik (1974) have shown that international markets
are not all closely correlated. Kaplanis (1997) showed that between 1990 and 1994,
London had the following cross-national correlation coefficients: USA (0.7), Germany
(0.4), Italy (0.2), Japan (0.3) and Australia (0.5). However, European markets tended to
have higher correlations, e.g. Germany/France (0.7), Netherlands/Germany (0.7),
due, presumably, to closer European integration.
Astute investors could exploit these less than perfect correlations by combining
investments in two or more markets, thus achieving a bodily shift downwards in the
risk profile. The effect is shown in Figure 10.3.
An illustration of this effect is shown in Figure 10.4. The author examined portfolio
formation on both the Polish and the London stock exchanges, and found that it
would have benefited Polish investors (but not British ones) to combine Warsaw- and
London-quoted stocks. Clearly, Warsaw stocks were more risky, possibly due to a
lower level of market efficiency, although it is interesting to observe the risk profile
flattening out at virtually the same size of portfolio for each market.
However, such opportunities may be disappearing. By the mid-1990s, the correlation between changes in US and European share price movements was estimated at
Domestic portfolio
Two-country portfolio
Well-diversified
international portfolio
Figure 10.3
The effect of international diversification
on portfolio risk
Number of securities in portfolio
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244 Part III Investment risk and return
Risk and portfolio size
0.6
0.5
Risk
0.4
Polish
0.3
Mixed
0.2
0.1
Figure 10.4
English
Combining the Warsaw
and the London
markets.
0
0
10
20
30
40
50
Number of shares
60
70
80
90
Source: Short, T. (2000) ‘Should foreign investors buy Polish shares?’ in T. Kowalski and S. Letza (eds) Financial Reform and
Institutions (Poznan University of Economics).
around 0.4 – Wall Street movements would ‘explain’ 40 per cent of movement in the
main European indices. But Brooks and Catao (2000) showed that rapid technical and
institutional change had raised the correlation to 0.8 by 2000.
They suggested several reasons for this convergence:
■
■
■
■
■
■
removal of controls on capital movements.
more efficient trading systems.
greater cross-border trading volumes.
more large companies obtaining listings on several markets.
more cross-border mergers and acquisitions with foreign activities accounting for
higher proportions of company profits.
easier access to information on foreign firms via the internet.
Due to these changes, equity markets have become more integrated, so that changes in
prices in one market are more easily and quickly transmitted to others, e.g. good news
for US banking shares is increasingly likely to lead to higher share prices for banking
shares across the world. This means that industry membership rather than location has
become a more important determinant of market value. In other words, investors should
diversify more by industry than by country to achieve optimal diversification benefits.
Brooks and Catao also showed that the most important factor explaining increased
correlation was developments in information technology. They found an overall correlation between European IT stocks and US IT stocks at May 2000 of 0.85, but for nonIT stocks, it was only 0.54. This implies that high-tech stocks now constitute a channel
whereby shocks in one market are spread throughout the world, e.g. in 2001, the information announced in the US about the reduced prospects and the stock write-downs
by internet technology suppliers Cisco, had a rapid impact not just on US technology
shares, but throughout the world stock markets.
10.5
SYSTEMATIC RISK
As specific risk can be diversified away by portfolio formation, rational investors expect
to be rewarded only for bearing systematic risk. Since systematic risk indicates the
extent to which the expected return on individual shares varies with that expected on
the overall market, we have to assess the extent of this co-movement. This is given by
the slope of a line relating the expected return on a particular share, ER j, to the return
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expected on the market, ER m. It is important to appreciate that ‘returns’ in this context
include both changes in market price and also dividends as we saw in the Pilkington
example. For the overall market, dividend returns may be measured by the average
dividend yield on the market index.
■
Example: Walkley Wagons
The case of Walkley Wagons is shown in Table 10.3. Investors anticipate four possible
future states of the economy. For every percentage point increase in the expected market return 1ER m 2, the expected return on Walkley shares 1ER j 2 rises by 1.2 percentage
points. Walkley thus outperforms a rising market. The graphical relationship between
ER j and ER m, shown in Figure 10.5, is known as the characteristics line. Its slope of 1.2
is the Beta coefficient. Beta indicates how the return on Walkley is expected to vary
alongside given variations in the return on the overall stock market.
Table 10.3
Possible returns from
Walkley Wagons
State of economy
E1
E2
E3
E4
ERm(%)
ERj (%)
10
20
5
15
12
24
6
18
Characteristics Line
ERj = α + β ERm
Slope =
30
E2
ERj
24
ΔERm
E1
6
0
The characteristics line:
no specific risk
■
ΔERj
E4
18
12
Figure 10.5
ΔERj
= 1.2
ΔERm
E3
5
10
15 20
ERm
25
The market model
In practice, because it is not easy to record people’s expectations, the measurement of
Beta cannot be done by looking forward. We have to measure Beta using past observations of the actual values of both the return on the individual company’s shares, and
also for the overall market, i.e. Rj and Rm respectively. So long as the past is accepted as
a reliable indication of likely future events (i.e. people’s expectations are moulded by
examination of the frequency distribution of past recorded outcomes), observed Betas
can be taken to indicate the extent to which Rj may vary for specified variations in Rm.
A regression line* is fitted to a set of recorded relationships, as in Figure 10.6. The
*Readers unfamiliar with the technique of regression analysis might refer to C. Morris, Quantitative
Approaches in Business statistics (Pearson).
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246 Part III Investment risk and return
hypothesized relationship is:
Rj aj bj Rm
and the fitted line is given by:
R â bˆ R u
j
market model
A device relating the expected
(in practice, actual) return from
individual securities to the
expected/actual return from the
overall stock market
j
j
m
where âj and bˆ j are estimates of the ‘true’ values of a and b, and u is a term included to
capture random influences, that are assumed to average zero. This regression model is
called the market model.
The intercept term, aj, deserves explanation. This is the return on security j when
the return on the market is zero, i.e. the return with the impact of market or systematic risk stripped out. Consequently, it indicates what return the security offers for
unsystematic risk. We might expect this to average out at zero over time, given the random character of sources of specific risk. However, it is by no means uncommon
empirically to record non-zero values for a. Notice that in Figure 10.5 a is zero.
Self-assessment activity 10.4
You read in the financial press, that the ‘experts’ are predicting overall stock market
returns of 25 percent next year. What return would you expect from holding Walkley
Wagons ordinary shares?
(Answer in Appendix A at the back of the book)
■
Systematic and unsystematic returns
Figure 10.6 shows an imaginary set of monthly observations relating to a given year,
say 2004, to which has been fitted a regression line. Clearly, unlike the expected values
displayed in Figure 10.5, most values actually lie off the line of best fit. These divergences are due to the sort of random, unsystematic factors suggested in Section 10.3.
For example, observation Z relates to the returns in May 2004. The overall return on
security j in this month, XZ, can be broken down into the market-related return, XY, due
to co-movement with the overall market, and the non-market return, or ‘excess return’,
YZ, due to unsystematic factors, which, in this month, have operated favourably. The
opposite appears to have applied in June 2004, indicated by point H. The marketrelated return ‘should’ have been FG, but the actual return of GH was dampened by
^
^
Rj = a + b Rm + u
R1
Characteristics
line
May 2004
Z
*
*
*
*
*
*
a
Y
*
*
*
*
F
*
*
June 2004
H
Figure 10.6
The characteristics line:
with specific risk
0
X
G
Rm
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unfavourable random factors represented by FH. This analysis implies that variations in
Rj along the characteristics line stem from market-related factors, which systematically affect all
securities, and that variations around the line represent the impact of factors specific to company j. The systematic relationship is captured by b.
Self-assessment activity 10.5
What is the significance of variations around the characteristics line? Relate this to a
particular company, say, British Airways.
(Answer in Appendix A at the back of the book)
Beta values: the key relationships
Beta is the slope of a regression line. The slope coefficient relating Rj to Rm equals the
covariance of the return on security j with the return on the market 1covjm 2 divided by
the variance of the market return 1s2m 2:
Beta j covjm
s2m
Since the covariance is equal to the correlation coefficient times the product of the
respective standard deviations 1rjmsjsm 2 (see Chapter 9), Beta is also equivalent to:
Beta j analysis of variance
A statistical technique for
isolating the separate determinants of the fluctuations
recorded in a variable over time
■
rjmsjsm
s2m
rjmsj
sm
Beta is thus the correlation coefficient multiplied by the ratio of individual security
risk to market risk. If the security concerned has the same total risk as the market, Beta
equals the correlation coefficient. For a given correlation, the greater the security’s systematic risk in relation to the market, the greater is Beta. Conversely, the lower the
degree of correlation, for a given risk ratio, the lower the Beta. Therefore, while Beta does
not measure risk in absolute terms, it is a risk indicator, reflecting the extent to which the
return on the single asset moves with the return on the market, i.e. it is a measure of relative
risk. To obtain a risk measure in absolute terms, we have to examine the total risk of
the security in more detail, using a statistical technique called analysis of variance. This
is explained in the appendix to this chapter.
Systematic risk: Beta measurement in practice
Betas are regularly calculated by several agencies. The Risk Measurement Service (RMS)
operated by the London Business School (LBS) is the best known in the UK. The RMS
is a quarterly updating service, based on monthly observations extending back over
five years, which computes the Betas of all firms listed both on the main market and
also on AIM. For each of the preceding 60 months, Rj is calculated for every security
and regressed against Rm. An extract from the RMS showing the components of the FT
30 Index of leading industrial shares is given in Table 10.4.
The Beta values of securities fall into three categories: ‘defensive’, ‘neutral’ and
‘aggressive’. An aggressive security has a Beta greater than 1. Its returns move by a
greater proportion than the market as a whole. In the case of GKN, with a Beta of 1.13,
for every percentage point change in the market’s return, the return on GKN’s shares
changes by 1.13 points. Such stocks are highly desirable in a rising market, although
the excess return is not guaranteed due to the possible impact of company-specific factors. A defensive share is BOC Group, with a Beta of 0.73, movements in whose returns
tend to understate those of the whole market. The returns on neutral stocks like Royal
Bank of Scotland, with its Beta of 1.01, parallel those on the market portfolio.
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248 Part III Investment risk and return
Table 10.4
Beta values of the
constituents of the
FT 30 Share Index
Company name
Allied Domecq
Holdings
BAE Systems
BG Group
BOC Group
Boots Group
BP
British Airways
British American
Tobacco
BT Group
Cadbury-Schweppes
Compass Group
Diageo
EMI Group
GKN
GlaxoSmithKline
Imperial Chemical
Industries
Invensys
ITV
Lloyds TSB group
LogicaCMG
Marks & Spencer
Group
Peninsular &
Oriental ‘Dfd’
Prudential
Reuters Group
Royal Bank of
Scotland
Royal & Sun
Alliance Ins Grp
Scottish Power
Tate & Lyle
Tesco
Vodafone Group
FTSE actuaries
classification
Beta
Variability
Specific
risk
Std Err
of Beta
RSquared
BevDstVn
.58
25
23
.16
14
Defence
Oil Intg
ChemCom
Ret Dept
Oil Intg
AirTran
Tobacco
1.19
.79
.73
.74
.83
1.66
.71
39
26
20
25
22
49
34
34
22
17
23
18
42
32
.21
.16
.13
.16
.13
.23
.20
23
24
32
21
34
28
11
Telcomfx
FoodProc
Bus Supp
BevDstVn
PublPrnt
AutoPrts
Pharmact
ChemSpec
1.53
.53
1.04
.28
1.14
1.13
.40
1.36
37
22
32
21
47
34
21
48
29
20
27
21
44
29
20
43
.19
.15
.19
.15
.23
.19
.15
.23
41
15
28
4
14
27
9
20
Electrnc
TVRadFil
Banks
Comp Svs
Ret Dept
1.36
1.54
1.19
1.36
.66
67
44
30
64
30
64
37
24
60
29
.26
.21
.16
.26
.19
10
30
38
11
12
Shipport
1.14
36
32
.20
24
Life Ass
PublPrnt
Banks
1.50
1.35
1.01
36
54
30
28
50
26
.18
.24
.17
42
15
27
InsNonLf
1.54
50
44
.23
23
Electric
FoodProc
FdrugRet
Telcomob
.44
.70
.59
1.03
24
35
26
35
23
33
24
31
.16
.20
.17
.20
8
10
13
22
Source: Risk Measurement Service, London Business School, Oct.–Dec. 2004.
Notice that the total risk of each security is shown as ‘variability’, e.g. 34 for GKN.
This is a standard deviation. Notice also that this invariably exceeds ‘Specific Risk’,
e.g. 29 for GKN. The difference indicates the market risk that cannot be diversified
away. (See the appendix to this chapter for a fuller explanation.)
Self-assessment activity 10.6
Suggest why the Beta values tend to cluster in a range of roughly 0.70 to 1.30.
(Answer in Appendix A at the back of the book)
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10.6
249
COMPLETING THE MODEL
The CAPM suggests that only systematic risk is relevant in assessing the required risk
premiums for individual securities, and we have established that Beta values reflect the
sensitivity of the returns on securities to movements in the market return. However, the
size of the risk premium on individual securities (or on efficient portfolios) will depend
on the extent to which the return on the investment concerned is correlated with the
return on the market. For a security perfectly correlated with the market, the market
risk premium would be suitable; otherwise the required return depends on the Beta.
The CAPM concludes that when an efficient capital market is in equilibrium, i.e. all
securities are correctly priced, the relationship between risk and return is given by the
security market line (SML), as depicted in Figure 10.7.
ERj
ERm
ERj = R f + bj (ERm – R f)
Security market
line (SML)
Market
portfolio
M
Rf
Figure 10.7
The security market
line
b=1
Beta
Self-assessment activity 10.7
Why is the Beta of the overall market equal to 1.0?
(Answer in Appendix A at the back of the book)
■
The security market line
The equation of the SML states that the required return on a share is made up of the
return on a risk-free asset, plus a premium for risk related to the market’s own risk premium, but which varies according to the Beta of the share in question:
ER j Rf bj 1ER m Rf 2
If Beta is 1, the required return is simply the average return for all securities, i.e. the
return on the benchmark market portfolio. Otherwise, the higher the Beta, the higher
are both the risk premium and the total return required. A relatively high Beta does not,
however, guarantee a relatively high return. The actual return depends partly on the
behaviour of the market, which acts as a proxy for general economic factors. Similarly,
expected returns for the individual security hinge on the expected return for the market. In a ‘bull’, or rising, market, it is worth holding high Beta (aggressive) securities.
Conversely, defensive securities offer some protection against a ‘bear’, or falling,
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250 Part III Investment risk and return
market. However, holding a single high Beta security is foolhardy, even on a rising market.
Undiversified investments, whatever their Beta values, are prey to specific risk factors.
Portfolio formation is essential to diversify away the risks unique to individual companies.
10.7
USING THE CAPM: ASSESSING THE REQUIRED RETURN
We may now apply the CAPM formula to derive the rate of return required by shareholders in a particular company. To do this, we require information on three components: the risk-free rate, the risk premium on the market portfolio and the Beta
coefficient.
■
Specifying the risk-free rate
No asset is totally risk-free. Even governments default on loans and defer interest payments. However, in a stable political and economic environment, government stock is
about the nearest we can get to a risk-free asset. Most governments issue an array of
stock. These range from very short-dated securities, such as Treasury Bills in the UK,
maturing in 1–3 months, to long-dated stock, maturing in 15 years or more and even,
exceptionally, undated stock, such as 3.5 per cent War Loan with no stated redemption
date. It is tempting to try to match up the life of the investment project with the corresponding government stock when assessing the risk-free rate. For example, when dealing with a ten-year project, we might look at the yield on ten-year government stock.
This may be unsatisfactory for several reasons. First, although the nominal yield to
maturity is guaranteed, the real yield may well be undermined by inflation at an
unknown rate. Second, there is an element of risk in holding even government stock.
This is reflected in the ‘yield curve’, which normally rises over time to reflect the
increasing liquidity risk of longer-dated stock. Third, although the yield to maturity is
given, a forced seller of the stock might have to take a capital loss during the intervening period, since bond values fluctuate over time with variations in interest rates.
A better way to specify Rf is to take the shortest-dated government stock available, normally three-month Treasury Bills, for which these risks are minimised. The current yield
appears in the financial press. This is about the same as LIBOR, the London Interbank
Offered Rate, the rate of interest at which banks lend to each other overnight.
■
Finding the risk premium on the market portfolio
The risk premium on the market portfolio, 1ER m Rf 2, is an expected premium.
Therefore, having assessed Rf, we need to specify ER m by finding a way of capturing the
market’s expectations about future returns. An approximation can be obtained by looking at past returns, which, taken over lengthy periods, are quite stable. The usual
approach with ordinary shares is to analyse the actual total returns on equities as compared with total returns on fixed-interest government stocks over some previous time
period. The results are likely to differ according to the period taken and the type of government stock used as the reference level (e.g. short-term securities such as Treasury Bills
or long-term gilts). However, studies seem to come up with quite stable results. For
example, Dimson and Brealey (1978), Day et al. (1987) and Dimson (1993) for the periods
1918–77, 1919–84 and 1919–92, respectively, showed average annual returns above the
risk-free rate of 9.0, 9.1 and 8.7 per cent (before taxes) for the market index in the UK.
Similar estimates have been obtained in the USA. In 1985, Mehra and Prescott
found that, after adjusting for inflation, equities delivered average real returns of 7 per
cent p.a. over a quarter of a century, compared with 1 per cent for Treasury bonds – a
real risk premium of 6 per cent. Mehra and Prescott found this premium ‘puzzling’ on
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the grounds that it seemed too large a premium for bearing non-diversifiable market
risk, especially given international opportunities for diversification. Fama and French
(2000) found the equity risk premium averaged 8.3 per cent p.a. over 1950–99, this
being well in excess of the 4.1 per cent p.a average for 1872–1949. Ibbotson Associates,
a consulting firm, specifies a risk premium above the US Treasury Bill return at 8.8 per
cent based on long-term research.
Dimson (1993) reported similar premiums in Japan (9.8 per cent, 1970–92), Sweden
(7.7 per cent, 1919–90) and the Netherlands (8.5 per cent, 1947–89), although the last
two estimates were in real terms, i.e. relative to domestic inflation.
A rather lower UK risk premium was recorded by Grubb (1993/4), at 6.2 per cent
for 1960–92. Grubb suggests that returns to equities in the 1970s and 1980s were exceptional and that under a ‘modern scenario of moderate growth and moderate inflation’,
a much lower premium on equities of only 2 per cent would be reasonable. This view
is supported by Wilkie (1994), who, after exhaustive study of past trends in dividend
yields and inflation, argues for a risk premium of 3 per cent for longer-term investment and 2 per cent for the short term. The evidence is inconclusive, but it is unlikely
that many finance directors would contemplate recommending projects with such low
premiums for risk.
However for shorter periods, say five or ten years (more akin to project lifetimes),
returns are highly volatile and sometimes negative. Clearly, people neither require nor
expect negative returns for holding risky assets! It therefore seems more sensible to
take the long-term average, and to accept that, in the short-term, markets exhibit unpredictable variations.
The investment banking arm of Barclays Bank, Barclays Capital (www.barcap.com)
publishes an annual analysis of equity and gilt-edged returns for various time periods
called the ‘Equity–Gilt Study’. Their data show real investment returns on equities and
government stock, and also on cash deposits. The long-term (105 years) equity risk premium is 4.0 per cent in real terms, and 4.1 per cent above the return on cash deposits.
Like many observers, Barclays Capital suggests that as the world economy moves
from the low growth/high inflation phase of the 1970s and 1980s to the high growth/
low inflation experienced more recently, equity returns were untypically high. One
reason for expecting lower future returns is technological progress, in general, and the
information revolution, in particular, resulting in shorter competitive advantage periods. Firms typically have less time to exploit a ‘first mover’s advantage’ before competitors arrive i.e. entry barriers are lower. Another likely depressant is the increased
openness of the world economy due to the activities of the World Trade Organisation.
A complicating factor is the ‘unusual demographic outlook of a shrinking population
and an expanding dependent population’. This suggests that the prices of financial
assets will fall relative to prices of goods and services, so that equities may offer a less
effective inflation hedge in the future.
The Barclays Capital website has an interactive facility that allows users to calculate
average annual returns for specified periods for the UK markets for any period over
1919 to date, and from 1925 to date for the USA. Table 10.5 shows some sample calculations for long periods and a year-by-year analysis for both countries.
In this table, the risk premium is expressed in nominal terms, i.e. before removing
inflation. The data suggest that, recently, equity premia have been high in relation to
longer-term outcomes. Note the remarkable similarity between UK and US premia.
The data are real geometric average annualised returns, i.e. they exclude the effect of
inflation.
One might conclude that, although the early 2000s were poor years, pulling down
the rolling average, there is little solid evidence in these data of a sea-change in the
equity risk premium given its more recent recovery. However, to reflect prevailing
thought, subsequent analysis will build in a risk premium for equities, i.e. the risk premium of the overall market portfolio, of 5%.
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252 Part III Investment risk and return
Table 10.5
UK
Equity-gilts relative
returns
Period
1925–2004
1925–1946
1946–1991
–92
–93
–94
–95
–96
–97
–98
–99
–2000
–01
–02
–03
–04
US
Equities
Gilts
Equity
premium
Equities
Bonds
Equity
premium
6.0
6.0
5.9
6.1
6.5
6.2
6.4
6.6
6.8
6.9
7.1
6.8
6.4
5.8
5.9
6.0
1.9
5.7
1.2
0.8
0.3
0.6
0.3
0.1
0.1
0.5
0.3
0.4
0.5
0.6
0.5
0.6
4.1
0.3
7.1
6.9
6.8
6.8
6.7
6.7
6.7
6.4
6.8
6.4
5.9
5.2
5.4
5.4
7.1
5.0
7.7
7.7
7.7
7.5
8.0
8.5
8.5
8.7
9.0
8.5
8.1
7.4
7.8
7.8
2.3
3.5
0.7
0.8
1.1
0.9
1.3
1.5
1.5
1.6
1.4
1.6
1.7
1.9
1.9
1.9
4.8
1.5
7.0
6.9
6.6
6.6
6.7
7.0
7.0
7.1
7.6
6.9
6.4
5.5
5.9
5.9
Source: Barclays Capital (www.barcap.com)
In probably the most thorough analysis to date of the equity risk premium, Dimson,
Marsh and Staunton (2002) updated and largely corroborated these figures in a study
of the equity risk premium for 16 countries, over a full century (1900–2000). They suggested that some earlier studies (including the earlier Dimson Studies!) might have
over-estimated the equity premium by excluding the First World War era, when equity returns were poor, and by confining the study to the performance of surviving
firms, thus excluding the relatively poor performers that had expired.
They found:
■
■
■
■
■
■
The average global real return on equity was 4.6 per cent.
Germany had offered the highest risk premium at 6.7 per cent.
Denmark offered the lowest risk premium at just 2 per cent.
In the US, for every 20-year period examined, equities outperformed bonds.
Only four countries – German, Netherlands, Sweden and Switzerland – exhibited
any 20-year periods over which bonds outperformed equities.
It is reasonable to expect a real equity premium of no more than 5 per cent or so in
the UK in the future.
The LBS team now offer an annual update of this analysis (www.abn-amro.com).
Their results are beginning to reveal some interesting, even perverse, findings. For
example, contrary to intuition, there appears to be no apparent positive relationship
between equity returns and GDP growth. Moreover, ‘Historically, buying into equity
markets with a high GDP growth rate has given a return that is below the return of
markets with a low GDP growth rate.’ Furthermore, for five years in a row up to 2004,
value investing beat growth investing. Over the period, 1999–2004, high-yield equities
returned 85 per cent compared to low-yield equities that returned 62 per cent.
This, of course, casts some doubt on the wisdom of firms’ re-investment policies. Time
will tell whether this is the beginning of a long-term trend.
Meanwhile, their updates on the real returns on equities and bonds allow us to infer
the following risk premia for equities over 1900–2004 for selected countries:
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Country
253
Real risk premium
on equities
Australia
Sweden
South Africa
USA
UK
World Average
Netherlands
Germany
Japan
Italy
6.4
6.4
6.2
5.7
4.1
4.0
3.8
1.0
2.8
0.5
Dimson et al. also discussed the ‘puzzle’ raised by Mehra and Prescott (1985), regarding the size of the equity premium. They suggest that, given the persistent worldwide
out-performance by equities, the risk element in equity investment, at least in developed, efficient markets, is overplayed. Prescott and McGrattan (2003) have revisited
this puzzle. They found that in the USA, after taking into account certain factors
ignored by Mehra and Prescott, e.g. taxes, regulatory constraints, diversification costs,
and focusing on long-term rather than short-term saving instruments, the puzzle is
solved. Allowing for all these factors, they found that the difference between average
equity and debt returns during peacetime is less than 1 per cent p.a., with the average
real equity return just under 5 per cent, and the average real return on debt instruments
a little under 4 per cent, a far lower premium than other writers have suggested.
Self-assessment activity 10.8
Visit the Barclays Capital website to conduct your own analysis of risk premia, e.g. update
the figures shown on Table 10.5.
■
Finding Beta
Beta values appear to be fairly stable over time, so we can use Beta values based on past
recorded data, such as those provided by the RMS, with a fair degree of confidence.
This is acceptable so long as the company is not expected to alter its risk characteristics
in the future: for example, by a takeover of a company in an unrelated field or a spinoff of unwanted activities.
■
The required return
We now demonstrate the calculation of the required return for the ‘aggressive’ share
British Airways, using the equation for the SML:
ER j Rf bj 1ER m Rf 2
The Beta recorded by the RMS at December 2004 was 1.66 (Table 10.4). At the same date,
the yield on three-month Treasury Bills was about 4.75 per cent. For British Airways, this
results in the following required return, assuming a market risk premium of 5 per cent:
ER 4.75% 1.6615%2 4.75% 8.30% 13.05%.
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Application to investment projects
As British Airways shareholders appear to require a return of 13.0 per cent, it may seem
reasonable to use this rate as a cut-off for new investments. However, two warnings are
in order.
First, the discount rate applicable to new projects often depends on the nature of the activity. For example, if a new project takes British Airways away from its present spheres
of activity into, say, mobile telephony, its systematic risk will alter, as suggested by the
Beta for Vodaphone of 1.03. The relevant premium for risk hinges on the systematic
risk of telecommunications rather than of airline operation. This suggests that we ‘tailor’ risk premiums, and thus discount rates, to particular activities. This aspect is
examined in the next chapter.
Self-assessment activity 10.9
What is the implied discount rate for investment by British Airways into retailing?
(Answer in Appendix A at the back of the book)
Second, the appropriate discount rate may depend upon the method of financing used. Until
now, we have implicitly been dealing with an all-equity financed company whose premium for risk is a reward purely for the business risk inherent in the company’s activity. In reality, most firms are partially debt-financed, exposing shareholders to financial
risk. Using debt capital increases the risk to shareholders because of the legallypreferred position of creditors. Defaulting on the conditions of the loan (e.g. failing to
pay interest) can result in liquidation if creditors apply to have the company placed
into receivership. The more volatile the earnings of the firm, the greater the risk of
default.
Financial risk raises the Beta of the equity, as shareholders demand additional returns to
compensate. The Beta of the equity becomes greater than the Beta of the underlying
activity. In Chapter 19, we shall see that observed Betas have two components, one to
reflect business risk and one to allow for financial risk. The Betas recorded by the RMS
are actually equity Betas, so the required return computed for British Airways (a highly geared company) is the shareholders’ required return, part of which is to compensate
for financial risk. However, when a company borrows, only the method of financing
changes; nothing happens to alter the riskiness of the basic activity. The cut-off rate
reflecting the basic risk of physical investment projects is often lower than the shareholders’ own required return.
In the previous sections, we have concentrated on developing the operational aspects
of the CAPM, without explaining the underlying theoretical relationships. The underlying theory is explained in Sections 10.8 and 10.9 and brought together in Section 10.10,
which you may omit at this stage. Section 10.11 discusses some general issues raised
by the CAPM.
10.8
THE UNDERPINNINGS OF THE CAPM
All theories rely on assumptions in order to simplify the analysis and expose the important relationships between key variables. In economics and related sciences, it is generally accepted that the validity of a theory depends on the empirical accuracy of its
predictions rather than on the realism of its assumptions (Friedman, 1953). However, if
we find that the predictions fail to correspond with reality, and we are satisfied that this
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is not due to measurement errors or random influences, then it is appropriate to
reassess the assumptions. The ensuing analysis, based on an amended set of assumptions, may lead to the generation of alternative predictions that accord more closely
with reality.
■
The assumptions of the CAPM
The most important assumptions are as follows:
1 All investors aim to maximise the utility they expect to enjoy from wealth-holding.
2 All investors operate on a common single-period planning horizon.
3 All investors select from alternative investment opportunities by looking at expected return and risk.
4 All investors are rational and risk-averse.
5 All investors arrive at similar assessments of the probability distributions of
returns expected from traded securities.
6 All such distributions of expected returns are normal.
7 All investors can lend or borrow unlimited amounts at a similar common rate of
interest.
8 There are no transaction costs entailed in trading securities.
9 Dividends and capital gains are taxed at the same rates.
10 All investors are price-takers: that is, no investor can influence the market price by
the scale of his or her own transactions.
11 All securities are highly divisible, i.e. can be traded in small parcels.
Several of these assumptions are patently untrue, but it has been shown that the
CAPM stands up well to relaxation of many of them. Incorporation of apparently
more realistic assumptions does not materially affect the implications of the analysis.
A full discussion of these adjustments is beyond our scope, but van Horne (2000) offers
an excellent analysis.
10.9
PORTFOLIOS WITH MANY COMPONENTS:
THE CAPITAL MARKET LINE
The theory behind the CAPM revolves around the concept of the ‘risk–return trade-off’.
This suggests that investors demand progressively higher returns as compensation for
successive increases in risk. The derivation of this relationship, known as the capital
market line (CML), relies on the portfolio analysis techniques examined in Chapter 9.
The reader may find it useful to re-read Section 9.7, where we explained the derivation of the efficient set available to an investor who can invest in a large number of
assets. One conclusion of this analysis was that the only way to differentiate between
the many portfolios in the efficient set was to examine the investor’s risk–return preferences, i.e. there was no definable optimal portfolio of equal attractiveness to all
investors.
■
Introducing a risk-free asset
The above conclusion applies only in the absence of a risk-free asset. A major contribution of the CAPM is to introduce the possibility of investing in such an asset. If we allow
for risk-free investment, the range of opportunities widens much further. For example,
on Figure 9.5 which is based on Figure 9.5 which showed an efficient frontier of AE,
consider the line from Rf, the return available on the risk-free asset, passing through
point T on the efficiency frontier. This represents all possible combinations of the
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256 Part III Investment risk and return
Expected return on portfolio (ERp)
Z
H
Capital
market line
(CML)
A
W
M
G
V
E
T
Rf
Figure 10.8
Risk of portfolio (standard deviation, sp)
The capital market line
Separation Theorem
A model that shows how individual perceptions of the optimal portfolio of risky securities
is independent (i.e. separate
from individuals’ different riskreturn preferences)
risk-free asset and the portfolio of risky securities represented by T. To the left of T, both
portfolio return and risk are less than those for T, and conversely for points to the right
of T. This implies that between Rf and T the investor is tempering the risk and return
on T with investment in the risk-free asset (i.e. lending at the rate Rf), while above T, the
investor is seeking higher returns even at the expense of greater risk (i.e. he borrows in
order to make further investment in T).
However, the investor can improve portfolio performance by investing along the
line RfV, representing combinations of the risk-free asset and portfolio V. He or she can
do better still by investing along RfWZ, the tangent to the efficient set. This schedule
describes the best of all available risk–return combinations. No other portfolio of risky
assets when combined with the risk-free assets allows the investor to achieve higher
returns for a given risk. The line RfWZ becomes the new efficient boundary.
Portfolio W is the most desirable portfolio of risky securities as it allows access to
the line RfWZ. If the capital market is not already in equilibrium, investors will compete to buy the components of W and tend to discard other investments. As a result,
realignment of security prices will occur, the prices of assets in W will rise and hence
their returns will fall; and conversely, for assets not contained in W. The readjustment
of security prices will continue until all securities traded in the market appear in a
portfolio like W, where the line drawn from Rf touches the efficient set. This adjusted
portfolio is the ‘market portfolio’ (re-labelled as M), which contains all traded securities,
weighted according to their market capitalisations. For rational risk-averting investors, this is
now the only portfolio of risky securities worth holding.
There is now a definable optimal portfolio of risky securities, portfolio M, which all
investors should seek, and which does not derive from their risk–return preferences.
This proposition is known as the Separation Theorem – the most preferred portfolio is
separate from individuals’ attitudes to risk. The beauty of this result is that we need
not know all the expected returns, risks and covariances required to derive the efficient set in Figure 10.8. We need only define the market portfolio in terms of some
widely used and comprehensive index.
However, having invested in M, if investors wish to vary their risk–return combination, they need only to move along RfMZ, lending or borrowing according to their
risk–return preferences. For example, a relatively risk-averse investor will locate at
point G, combining lending at the risk-free rate with investment in M. A less cautious
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capital market line
A relationship tracing out the
efficient combinations of risk
and return available to investors
prepared to combine the
market portfolio with the riskfree asset
■
257
investor may locate at point H, borrowing at the risk-free rate in order to raise his or
her returns by further investment in M, but incurring a higher level of risk. However,
we would still need information on attitudes to risk to predict how individual investors
behave.
The line RfMZ is highly significant. It describes the way in which rational investors
– those who wish to maximise returns for a given risk or minimise risk for a given
return – seek compensation for any additional risk they incur. In this sense, RfMZ
describes an optimal risk–return trade-off that all investors and thus the whole market will pursue; hence, it is called the capital market line (CML).
The capital market line
The CML traces out all optimal risk–return combinations for those investors astute
enough to recognise the advantages of constructing a well-diversified portfolio. Its
equation is:
ER p Rf c
1ER m Rf 2
d sp
sm
Its slope signifies the rate at which investors travelling up the line will be compensated for each extra unit of risk, i.e. 1ER m Rf 2>sm units of additional return.
For example, imagine investors expect the following:
Rf 10%
ER m 20%
sm 5%
so that
c
ER m Rf
20% 10%
d c
d 2
sm
5%
Every additional unit of risk that investors are prepared to incur, as measured by
the portfolio’s standard deviation, requires compensation of two units of extra return.
With a portfolio standard deviation of 2 per cent, the appropriate return is:
ER p 10% 12 2%2 14%
for sp 3%, ER p 16%; for sp 4%, ER p 18%; and so on.
Anyone requiring greater compensation for these levels of risk will be sorely disappointed.
To summarise, we can now assess the appropriate risk premiums for combinations
of the risk-free asset and the market portfolio, and therefore the discount rate to be
applied when valuing such portfolio holdings. The final link in the analysis of risk
premiums is an explanation of how the discount rates for individual securities are
established and hence how these securities are valued. This was already provided by
the discussion of the SML in Section 10.6.
10.10
HOW IT ALL FITS TOGETHER: THE KEY RELATIONSHIPS
The CAPM on first acquaintance may look complex. However, its essential simplicity
can be analysed by reducing it to the three panels of Figure 10.9.
Panel I shows the CML, derived using the principles of portfolio combination
developed in Chapter 9. The CML is a tangent to the envelope of efficient portfolios of
risky assets, the point of tangency occurring at the market portfolio, M. Any combination along the CML (except M itself) is superior to any combination of risky assets
alone. In other words, investors can obtain more desirable risk–return combinations by
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258 Part III Investment risk and return
PANEL I
PANEL II
ER
Rf MZ summarises efficient
portfolios of M plus risk-free asset Z
A
ERm
Rf
Optimal portfolio
of risky assets
CL
ΔERj
B
C
(23%)
ΔERm
M
(20%)
All inefficient
portfolios and
individual assets
in this space – for
asset C.
AB = Syst. risk
BC = Unsyst. risk
(10%)
sm(5%)
D
(15%)
s
ERm − R f
sm
sp
Indicates the required risk premium
for any portfolio comprising the
risk-free asset and the market
portfolio of risky assets.
ERc (23%)
ERm (20%)
α
The capital market line (CML)
ERp = R f +
Information about ERj also appears
on the CML diagram, e.g. viz, asset C,
which has greater systematic risk
than the market portfolio
SML
ΔER
b = ΔER j
m
E
0
ERj
CML
40%
ERc
PANEL III
ERj
Rf
0
ERm
C
M
(10%)
0
b = 1 b = 1.3 b
The characteristics line (CL)
The security market line (SML)
Expresses the relationship between
the expected return on security j
for given values of the return expected
on the portfolio.
(Slope = b, measured from past data
by regression analysis).
ERj = R f + bj [ERm − R f]
Indicates the appropriate required
return on individual assets (and
also inefficient portfolios).
Figure 10.9 The CAPM: the three key relationships
mixing the risk-free asset and the market portfolio to suit their preferences, i.e. according to whether they wish to lend or borrow.
The slope of the CML, given by 3 1ER m Rf 2>sm 4 defines the best available terms for
exchanging risk and return. It is desirable to hold a well-diversified portfolio of securities in order to eliminate the specific risk inherent in individual securities like C.
When holding single securities, investors cannot expect to be rewarded for total risk
(e.g. 15 per cent for C) because the market rewards investors only for bearing the undiversifiable or systematic risk. The extent to which risk can be eliminated depends on
the covariance of the share’s return with the return on the overall market. Hence, the
degree of correlation with the return on the market influences the reward from holding a security and thus its price.
The characteristics line in Panel II shows how the return on an individual share,
such as C, is expected to vary with changes in the return on the overall market. Its
slope, the Beta, indicates the degree of systematic risk of the security.
The security market line in Panel III shows the market equilibrium relationship
between risk and return, which holds when all securities are ‘correctly’ priced. Clearly,
the higher the Beta, the higher the required return. Although Beta is not a direct measure of systematic risk, it is an important indicator of relevant risk.
The decomposition of the overall variability, or variance, of the share’s return into
systematic and unsystematic components is explained in the appendix to this chapter.
It can be demonstrated by focusing on security C in Panel III of Figure 10.9. Security
C lies to the north-east of the market portfolio because its Beta of 1.3 exceeds that of
the overall market. If the market as a whole is expected to generate a return of 20 per
cent, and the risk-free rate is 10 per cent, C’s expected return is:
ER C 10% 1.3 120% 10%2 10% 13% 23%
This reward compensates only for systematic risk, rather than for the share’s total
risk. Of the total risk of C, represented by distance OD, only OE is relevant.
The risk–return trade-off, given by the slope of the CML, is 120% 10%2>5% 2,
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since the risk of the market itself is 5 per cent. For C, with overall risk of 15 per cent,
we would not expect to obtain compensation at this rate (i.e. 2 15% 30% giving
an overall return of 40 per cent), because much of the total risk can be diversified away.
Observe that a variety of required return figures could have emerged from our
calculation – in fact, anything along the perpendicular ZD in Panel I of Figure 10.9,
depending on the extent to which security C is correlated with the market portfolio.
The nearer C lies to Z, the greater the correlation and the higher the required return,
and conversely, should C be nearer to D. This reflects the changing balance between
the two risk components along ZD.
If the market rewarded total risk, the return offered on security C would be the
risk-free rate of 10 per cent supplemented by the risk–return trade-off (2 the total
security risk of 15 per cent), yielding a total of 40 per cent. However, because the total
risk is partly diversifiable, the market offers a return of just 23 per cent for security C.
This relationship is indicated on Panel I of Figure 10.9 by the distances AB and BC, representing respectively the systematic and specific risk components of security C’s total
risk (not to scale).
Self-assessment activity 10.10
You expect the stock market to rise in the next year or so. Could you beat the market
portfolio by holding, say, the five securities with the highest Betas?
(Answer in Appendix A at the back of the book)
10.11
RESERVATIONS ABOUT THE CAPM
The CAPM analyses the sources of asset risk and offers key insights into what rewards
investors should expect for bearing these risks. However, certain limitations detract
from its applicability.
■
It relies on a battery of ‘unrealistic’ assumptions
It is often easy to criticise theories for the lack of realism of their assumptions, and certainly, many of those embodied in the CAPM, especially concerning investor behaviour, do not seem to reflect reality. However, if the aim is to provide predictions that can
be tested against real world observations, the realism of the underlying assumptions is
secondary. Obviously, if the predictions themselves do not accord reasonably closely
with reality, then the theory is undoubtedly suspect.
■
Single time period
A key assumption of the CAPM is that investors adopt a one-period time horizon for
holding securities. Whatever the length of the period (not necessarily one year), the rates
of return incorporated in investor expectations are rates of return over the whole holding period, assumed to be common for all investors. This provides obvious problems
when we come to use a required return derived from a CAPM exercise in evaluating an
investment project. Quite simply, we may not compare like with like. If an investor
requires a return of, say, 25 per cent, over a five-year period, this is rather different from
saying that the returns from an investment project should be discounted at 25 per cent
p.a. Attempts have been made, notably by Mossin (1966), to produce a multi-period version of the CAPM, but its mathematical complexity takes it out of the reach of most practising managers, especially those inclined to scepticism about the CAPM itself.
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260 Part III Investment risk and return
10.12
TESTING THE CAPM
Many writers have observed that, in principle, the CAPM is untestable, since it is based
on investors’ expectations about future returns, and expectations are inherently awkward to measure. Hence, tests of the CAPM have to examine past returns and take
these as proxies for future expected returns, based on a key premise. If a long enough
period is examined, mistaken expectations are likely to be corrected, and people will
come to rely on past average achieved returns when formulating expectations. Greatly
simplified, the essence of the research methods is as follows.
Research usually proceeds in two stages. First, using time series analysis over a
lengthy period applied to a large sample of securities (say 750), researchers estimate
both the Beta for each security and its average return. Relying heavily on market efficiency, these estimates are taken to be estimates of the ex ante expected return, i.e. it is
assumed that rational investors will be strongly influenced by past returns and their
variability when formulating future expectations.
Second, the researcher tries to locate the SML to investigate whether it is upward sloping, as envisaged by the CAPM. The 750 pairs of estimates for Beta and the average return
for each security are used as the input into a cross-section regression model of the form:
Ri a1 a2bi ui
where Ri is the expected return from security i, a1 is the intercept term (i.e. the risk-free
rate), a2 is the slope of the SML and ui is an error term.
If the CAPM is valid, the measured SML would appear as in the steeper line on
Figure 10.10, with an intercept approximating to recorded data for the risk-free rate:
for example, the realised return on Treasury Bills.
Several early studies (e.g. Black et al., 1972; Fama and McBeth, 1973) did seem to
support the positive association between Beta and average stock returns envisaged by
the CAPM for long periods up to the late 1960s. However, evidence began to emerge
that the empirical SML was much flatter than implied by the theory and that the intercept was considerably higher than achieved returns on ‘risk-free’ assets.
Some researchers have continued to test the validity of the CAPM, but others, following Ross (1976), have concluded that some of the ‘rogue’ results stem from intrinsic difficulties concerning the CAPM that make it inherently untestable. In the process,
they have developed an alternative theory, based on the Arbitrage Pricing Model
(APM), discussed in Section 10.13.
Some of the reasons why the CAPM is thought to be nigh impossible to test adequately are as follows:
1 It relies on specification of a risk-free asset – there is some doubt whether such an
asset really exists.
2 It relies on analysing security returns against an efficient benchmark portfolio, the
Theoretical SML
Expected and
actual returns
Empirical SML
Rf
Rf
Figure 10.10
Theoretical and
empirical SMLs
0
Beta
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market portfolio, usually proxied by a widely-used index. Because no index captures
all stocks, the index portfolio itself could be inefficient, as compared with the full
market portfolio, thus distorting empirical results.
3 The model is unduly restrictive in that it includes only securities as depositories of
wealth. A full ‘capital asset pricing model’ would include all forms of asset, such as
real estate, oil paintings or rare coins – in fact, any asset that offers a future return.
Hence, the CAPM is only a security pricing model.
Fama and French (1992) made a thorough test of the CAPM, finding no evidence for
the ‘correct’ relationship between security returns and Beta over the period 1963–90.
The cross-section approach supported neither a linear nor a positive relationship. It
appeared that average stock returns were explained better by company size as measured by market capitalisation, large firms generally offering lower returns, and by the
ratio of book value of equity to market value, returns being positively associated with
this variable. They concluded that rather than being explained by a single variable,
Beta, security risk was multi-dimensional.
Neither of the UK studies conducted by Beenstock and Chan (1986) and by Poon and
Taylor (1991) found significant positive relationships between security returns and Beta.
Acting on Levis’ (1985) observation for the period 1958–82 that smaller firms tend to outperform larger firms (although erratically), Strong and Xu (1997) attempted to replicate
the Fama and French analysis in a UK context. Specifically, they investigated whether
Beta could explain security returns and whether it was outweighed by ‘the size effect’.
For the period 1960–92, they found a positive risk premium associated with Beta in
isolation, but this became insignificant when Beta was combined with other variables
in a multiple regression. For the whole period, market value dominated Beta, but over
1973–1992, it was itself insignificant compared with book-to-market value of equity,
and gearing. However, the explanatory power of various combinations of variables
used was poor, never exceeding an R2 of 8 per cent. Overall, there appeared to be a size
effect, but it did not operate in as clear or as stable a fashion as in the Fama and French
study of US data.
10.13
FACTOR MODELS
It is not too surprising that some of the studies listed in the previous section do not support the notion that Beta is the most important determinant of the return on quoted
securities. In the CAPM, the only independent variable driving individual security
returns is the return on the market, i.e. there is a single factor at work. In reality, everyone knows there are many factors at work, but the researcher is hoping that their various impacts will all be rolled up into this single market factor.
However, the returns on a share react to general industry or sector changes in addition to general market changes. These aspects are all confused in Beta. This helps
explain why the CAPM is such a poor explanatory model. The explanatory power of
a regression model like the CAPM is measured by the R-Squared, or Coefficient of
Determination, which is measured on a scale of zero to 1. These are shown in Table 10.4
in the final column. While expert opinions vary on this, it is commonly accepted that
an R-Squared of above 50 per cent indicates a strong relationship, i.e. a high degree of
explanatory power. The highest figure shown in the table is 42 per cent. The interpretation we have to put on this is that there are other, perhaps many other, factors at
work impacting on security returns.
Whereas the CAPM is a single factor model, many researchers like Fama and French
(1992) have attempted to develop multi-factor models. A multi-factor model will include
two elements:
■
a list of factors that have been identified as having a significant influence on security
returns
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262 Part III Investment risk and return
■
a measure of the sensitivity of the return on particular securities’ returns to changes
in these factors.
In the CAPM, there is only the one factor, the return on the market portfolio, and the
sensitivity is measured by each security’s Beta. As in the CAPM, which distinguishes between specific and market-related risk, there are two types of risk – factor risk,
and non-factor risk. Thus, variations in the returns on stocks can be explained by
variations in the identified factor(s) (analogous to market risk) and variations due to
background ‘noise’, i.e. changes in factors not included in the model (analogous to
specific risk).
■
A two-factor model
In the UK, 60 per cent of the economy is represented by consumer expenditure, which is
largely driven by income growth and the ‘feel-good factor’ from rising house prices.
Bear also in mind that the stock market is generally supposed to herald movements in
the overall economy one to two years ahead. Therefore, a model devised to explain stock
market returns in terms of interest rates and house prices would be quite plausible.
This would be a two-factor model of the following form:
Rj a b1F1 b2F2 ej
where Rj is the return on stock j in the usual sense, a is the intercept term, F1 and F2 are
the two identified factors, interest rates and house prices, b1 and b2 are the sensitivity
coefficients and e j is an error term.
The values of the parameters a, b1 and b2 would be found by multiple regression
analysis, while the error term is assumed to average zero. Say the values established
by empirical investigation are:
a 0.01
b1 2.0
b2 0.2
This means that for every 1 per cent point change in interest rates, individual security returns change by twice as much, i.e. by two percentage points. Similarly, for every
1 per cent point change in the house price index, security returns change by 0.2 of a
percentage point.
It should be stressed that the explanatory factors in the equation would be common
to all firms, but the sensitivity coefficients, the ‘Betas’, would vary according to how
closely ‘geared’ the returns on each firm were to each factor. For example, if one identified factor was the sterling/dollar exchange rate, we would expect to see much higher sensitivity for a firm exporting to, or operating in, the USA, compared to one
conducting most of its operations in the domestic arena.
10.14
THE ARBITRAGE PRICING THEORY
The most fully developed multi-factor model is the Arbitrage Pricing Theory (APT),
developed by Ross (1976). Unlike the CAPM, APT does not assume that shareholders
evaluate decisions within a mean–variance framework. Rather, it assumes the return on
a share depends partly on macroeconomic factors and partly on events specific to the
company. Instead of specifying a share’s returns as a function of one factor (the return
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on the market portfolio), it specifies the returns as a function of multiple macroeconomic factors upon which the return on the market portfolio depends.
The expected risk premium of a particular share would be:
ER j Rf b1 1ER factor 1 Rf 2 b2 1ER factor 2 Rf 2 p ej
where ER j is the expected rate of return on security j, ER factor 1 is the expected return on
macroeconomic factor 1, b1 is the sensitivity of the return on security j to factor 1 and ej
is the random deviation based on unique events impacting on the security’s returns.
The bracketed terms are thus risk premiums, as found in the CAPM.
Diversification can eliminate the specific risk associated with a security, leaving
only the macroeconomic risk as the determinant of required security returns. A rational investor will arbitrage (hence the name) between different securities if the current
market prices do not give sufficient compensation for variations in one or more factors
in the APT equation.
The APT model does not specify what the explanatory factors are; they could be the
stock market index, Gross National Product, oil prices, interest rates and so on.
Different companies will be more sensitive to certain factors than others.
In theory, a riskless portfolio could be constructed (i.e. a ‘zero Beta’ portfolio) which
would offer the risk-free rate of interest. If the portfolio gave a higher return, investors
could make a profit without incurring any risk by borrowing at the risk-free rate to
buy the portfolio. This process of ‘arbitrage’ (i.e. taking profits for zero risk) would
continue until the portfolio’s expected risk premium was zero.
The Arbitrage Pricing Theory avoids the CAPM’s problem of having to identify the
market portfolio. But it replaces this problem with possibly more onerous tasks. First,
there is the requirement to identify the macroeconomic variables. American research
indicates that the most influential factors in explaining asset returns in the APT framework are changes in industrial production, inflation, personal consumption, money
supply and interest rates (McGowan and Francis, 1991).
Tests of the APT, especially for the UK, are still in their relative infancy. However,
Beenstock and Chan (1986) found that, for the period 1977–83, the first few years of the
UK’s ‘monetarist experiment’, share returns were largely explained by a set of monetary factors – interest rates, the sterling M3 measure of money supply and two different measures of inflation, all highly interrelated variables. In 1994, Clare and Thomas
reported results from analysing 56 portfolios, each containing 15 shares sorted by Beta
and by size of company by value. For the Beta-ordered portfolios, the key factors were
oil prices, two measures of corporate default risk, the Retail Price Index (RPI), private
sector bank lending, current account bank balances and the yield to redemption on UK
corporate loan stock. Using portfolios ordered by size, the key factors reduced to one
measure of default risk and the RPI. Again, there was much intercorrelation among
variables, but the return on the stock market index, although included in the initial
tests, appeared in none of these final lists.
Once the main factors influencing share returns are established, there remain the
problems of estimating risk premiums for each factor and measuring the sensitivity of
individual share returns to these factors. For this reason, the APT is currently only in
the prototype stage, and yet to be accepted by practitioners.
10.15
ISSUES RAISED BY THE CAPM: SOME FOOD FOR
MANAGERIAL THOUGHT
The CAPM raises a number of important issues, which have fundamental implications
for the applicability of the model itself and the role of diversification in the armoury of
corporate strategic weapons.
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264 Part III Investment risk and return
■
Should we trust the market?
Legally, managers are charged with the duty of acting in the best interests of shareholders, i.e. maximising their wealth (although company law does not express it quite
like this). This involves investing in all projects offering returns above the shareholders’
opportunity cost of capital. The CAPM provides a way of assessing the rate of return
required by shareholders from their investments, albeit based partly on past returns. If
the Beta is known and a view is taken on the future returns on the market, then the
apparently required return follows. This becomes the cut-off rate for new investment
projects, at least for those of similar systematic risk to existing activities. This implies
that managers’ expectations coincide with those of shareholders or, more generally,
with those of the market. If, however, the market as a whole expects a higher return
from the market portfolio, some projects deemed acceptable to managers may not be
worthwhile for shareholders.
The subsequent fall in share price would provide the mechanism whereby the market communicates to managers that the discount rate applied was too low. The CAPM
relies on efficiently-set market prices to reveal to managers the ‘correct’ hurdle rate
and any mistakes caused by misreading the market. The implication that one can trust
the market to arrive at correct prices and hence required rates of return is problematic
for many practising managers, who are prone to believe that the market persistently
undervalues the companies that they operate. Managers who doubt the validity of the
EMH are unlikely to accept a CAPM-derived discount rate.
■
Should companies diversify?
The CAPM is based on the premise that rational shareholders form efficiently diversified portfolios, realising that the market will reward them only for bearing marketrelated risk. The benefits of diversification can easily be obtained by portfolio formation,
i.e. buying securities at relatively low dealing fees. The implication of this is that corporate diversification is perhaps pointless as a device to reduce risk because companies are seeking
to achieve what shareholders can do themselves, probably more efficiently. Securities are far
more divisible than investment projects and can be traded much quicker when conditions alter. So why do managers diversify company activities?
An obvious explanation is that managers have not understood the message of the
EMH/CAPM, or doubt its validity, believing instead that shareholders’ best interests
are enhanced by reduction of the total variability of the firm’s earnings. For some
shareholders, this may indeed be the case, as a large proportion of those investing
directly on the stock market hold undiversified portfolios.
Many small shareholders were attracted to equity investment by privatisation
issues or by Personal Equity Plans and their successor, ISAs (Individual Savings
Accounts). Larger shareholders sometimes tie up major portions of their capital in a
single company in order to take, or retain, an active part in its management. In such
cases, market risk, based on the co-variability of the return on a company’s shares with
that on the market portfolio, is an inadequate measure of risk. The appropriate measure of risk for capital budgeting decisions probably lies somewhere between total risk,
based on the variance, or standard deviation, of a project’s returns, and market risk,
depending on the degree of diversification of shareholders.
A more subtle explanation of why managers diversify is the divorce of ownership
and control. Managers who are relatively free from the threat of shareholder interference in company operations may pursue their personal interests above those of shareholders. If an inadequate contract has been written between the manager-agents and
the shareholder-principals, managers may be inclined to promote their own job security. This is understandable, since shareholders are highly mobile between alternative
security holdings, but managerial mobility is often low. To managers, the distinction
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265
between systematic risk and specific risk may be relatively insignificant, since they have a vested interest in minimising total risk to increase their job security. If the company flounders,
it is of little comfort for them to know that their personal catastrophe has only a minimal effect on well-diversified shareholders.
As we will see in Chapter 20, there are many motives for diversification beyond
merely reducing risk. However, it is common to justify diversification to shareholders purely on these grounds, at least under certain types of market imperfection.
When a company fails, there are liquidation costs to bear as well as the losses entailed
in selling assets at ‘knock-down’ prices. These costs may result in both creditors and
shareholders failing to receive full economic value in the asset disposal. Although this
will not devastate a well-diversified shareholder, the resulting hole in his or her portfolio will require filling in order to restore balance. Company diversification may
reduce these risks and also the costs of portfolio disruption and readjustment.
St Gobain
Despite contemporary strategic thinking, the conglomerate is not extinct everywhere. In
France, famous for its policy of nurturing national champions, the glass-maker, St Gobain, privatised in 1986, has since thrived on a diet of acquisition of often unrelated businesses. The
Chairman/CEO, Jean-Louis Beffa, is scornful of the drive for focus as firms try to concentrate
operations on ‘core’ areas of business. M. Beffa has overseen the acquisition of over 900 companies, including many in the distribution of building materials, an activity uncharted by St
Gobain until the 1990s.
Beffa says about ideas of focus:
Look at Siemens. They are better for having a mix of companies from which they can
get a strong cash flow.
In support, he points to St Gobain’s balancing of distribution operations, covering a broad
range of items for the building trade and operated mainly on a regional basis, with the global
manufacturing of flat glass (where St Gobain is world number 2 after Asahi of Japan), and containers. Glass production is highly cyclical, changing with the oscillations of the world economy, whereas the distribution of building materials is far more stable because different national
markets have their own peculiar patterns of troughs and peaks. St Gobain’s diversification
strategy gives it the consistent financial fire-power – cash flow of Euros 2.8 billion in 2003 –
to finance growth by capital spending and by acquisition.
Beffa also stresses the need to enable executives to build up expertise in certain areas and
to transfer skills horizontally across the overall business, for example legal expertise acquired in
different fields that can be applied elsewhere, and experience of using specific financial instruments in different parts of the world. It also encourages the flow of ideas between divisions
through nine overseas ‘delegate offices’, which act as collection points for ideas so that executives can transmit them with utmost efficiency.
Of course, one might argue that a growth-oriented policy that makes the firm increasingly
important to the national economy also makes it more likely that the state will step in with
financial assistance when necessary. St Gobain makes a virtue of this by suggesting that governments should help to fuel national economic growth by state investment, in their case, in
developing novel applications or glass structures, for example for flat-screen TVs.
Source: Based on Peter Marsh, Financial Times, 4 January 2005.
Self-assessment activity 10.11
In the light of the St Gobain case, explain why it might good to be a conglomerate.
(Answer in Appendix A at the back of the book)
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266 Part III Investment risk and return
SUMMARY
We have examined the nature of the risks affecting the holders of securities and have
begun to discuss whether the return required by shareholders, as implied by market
valuations, can be used as a cut-off rate for new investment projects.
Key points
■
Security risk can be split into two components: risk specific to the company in question, and the variability in return due to general market movements.
■
Rational investors form well-diversified portfolios to eliminate specific risk.
■
The most efficient portfolio of risky securities is the market portfolio, although
investors may mix this with investment in the risk-free asset in order to achieve
more preferred risk–return combinations along the capital market line.
■
The risk premium built into the required return on securities reflects a reward for
systematic risk only.
■
The risk premium on a particular share depends on the risk premium on the overall market and the extent to which the return on the security moves with that of the
whole market, as indicated by its Beta coefficient.
■
This premium for risk is the second term in the equation for the security market
line:
ER j Rf bj 1ER m Rf 2.
■
Practical problems in using the CAPM centre on measurement of Beta, specification
of the risk-free asset and measurement of the market’s risk premium.
■
In an all-equity financed company, the return required by shareholders can be used
as a cut-off rate for new investment if the new project has systematic risk similar to
the company’s other activities.
■
There is some debate about whether managers should diversify company activities
merely in order to lower risk.
■
Empirical studies seem to throw increasing doubt on the CAPM.
■
The main proposed alternative, the Arbitrage Pricing Theory (APT), relies on fewer
restrictive assumptions but is still in the prototype stage.
Further reading
As with basic portfolio theory, Copeland and Weston (2004) offer a rigorous treatment of the
derivation of the formulae used in this chapter. Brealey, Myers and Allen (1996) offer an alternative, less mathematical treatment. You should also read the famous critique of the CAPM by
Roll (1977). Fama and French’s paper (1992), although difficult, is essential reading, as is Strong
and Xu (1997), for a UK perspective.
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APPENDIX
ANALYSIS OF VARIANCE
The total risk of a security 1sT 2, comprising both unsystematic risk 1sUSR 2, and systematic risk 1sSR 2, is measured by the variance of returns, which can be separated into
the two elements. Imagine an asset with total risk of sT2 500, of which 80 per cent
(400) is explained by systematic risk factors, the remainder resulting from factors specific to the firm:
sT 2 500 sSR2 sUSR2 100 400
In terms of standard deviations, sSR 2400 20 and sUSR 2100 10. Notice
that we cannot express the overall standard deviation by summing the two component standard deviations – variances are additive, but not standard deviations – the
square root of the total risk is 2500 22.4, rather than the sum of sSR and
sUSR 120 10 302.
In regression models, the extent to which the overall variability in the dependent
variable is explained by the variability in the independent variable is given by the Rsquared 1R2 2 statistic, the square of the correlation coefficient. The R2 is thus a measure
of ‘goodness of fit’ of the regression line to the recorded observations. If all observations lie on the regression line, R2 equals 1 and the variations in the market return fully
explain the variations in the return on security j. In this case, all risk is market risk. It
follows that the lower is R2, the greater the proportion of specific risk of the security.
For investors wishing to diversify away specific risk, such securities are highly attractive. Notice that an R2 of 1 does not entail a Beta of 1, as Figure 10.11 illustrates. All
three securities have R2 of 1, but they have different degrees of market risk, as indicated by their Betas.
Rj
‘Aggressive’
b>1
R2 = 1
‘Neutral’
b=1
R2 = 1
‘Defensive’
b<1
R2 = 1
Figure 10.11
Alternative characteristics lines
Rm
In the example above, the R2 of 80 per cent would correspond to a correlation
coefficient, rjm, of 20.8 0.89. Looking at the standard deviations, we can infer
that 0.89 of the standard deviation is market risk, i.e. 10.89 22.42 19.94, while the
specific risk 11 rjm 2 22.4 10.11 22.42 2.46. Let us re-emphasise these
relationships:
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268 Part III Investment risk and return
Market, or systematic risk, is:
R2 the overall variance, sT2 ; or 1rjm the overall standard deviation, sT 2
10.8 5002 400; or 10.89 22.4%2 19.94%
Specific risk is:
11 R2 2 overall variance, sT 2 ; or 11 rjm 2 overall standard deviation sT
10.2 5002 100; or 10.11 22.4%2 2.46%.
The reader may find it useful to test out these relationships using the data provided in Table 10.4 (‘Variability’ is total risk expressed as a standard deviation). However,
not all cases work out neatly owing to rounding errors.
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Chapter 10 Setting the risk premium: The Capital Asset Pricing Model
QUESTIONS
Questions with a coloured number have a Solution in Appendix B on page 699.
1 The ordinary shares of Firm A have a Beta of 1.23. The risk-free rate of interest is 5 per cent, and the risk premium achieved on the market index over the past 20 years has averaged 11.5 per cent p.a. What is the future
expected return on A’s shares?
If you believe that overall market returns will fall to 8 per cent in future years, how does your answer
change?
2 Supply the missing links in the table:
(i)
(ii)
(iii)
(iv)
ERj
Rf
B
ERm
19%
17%
?
15%
?
5%
4%
7%
1.10
?
0.75
0.65
18%
12%
10%
?
3 Locate the security market line (SML) given the following information: Rf 8%, ER m 12%.
4 Which of the following shares are over-valued?
Beta
A
B
C
Current Rate of Return
0.7
1.3
0.9
7%
13%
9%
The risk-free rate is 5 per cent, and the return on the market index is 10 per cent.
5 The market portfolio has yielded 12 per cent on average over past years. It is expected to offer a risk premium in future years of 7%. The standard deviation of its return is 8 per cent. The risk-free rate is 5 per cent.
(i) What is the expected return from the market portfolio?
(ii) Draw a diagram to show the location of the Capital Market Line.
(iii) What is the expected return on a portfolio comprising 50% invested in the market portfolio and 50%
invested in the risk-free asset?
(iv) What is the risk of the portfolio in (iii)?
(v) What is the market trade-off between portfolio risk and return suggested by these figures?
6 The following figures relate to monthly observations of the return on a widely used stock market index 1Rm 2
and the return on a particular ordinary share 1Rj 2 over a period of six months.
Month
Rm
Rj
1
2
3
4
5
6
5
10
12
3
4
7
4
8
9.6
2.4
3.2
5.6
(a) Plot these data on a graph and deduce the value of the Beta coefficient.
(b) To what extent are variations in Rm due to specific risk factors?
(c) Calculate the systematic risk of the security. (NB: systematic risk b2s2m.)
269
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270 Part III Investment risk and return
7 Z plc is a long-established company with interests mainly in retailing and property development. Its current
market capitalisation is £750 million. The company trades exclusively in the UK, but it is planning to expand
overseas either by acquisition or joint venture within the next two years. The company has built up a portfolio
of investments in UK equities and corporate and government debt. The aim of developing this investment portfolio is to provide a source of funds for its overseas expansion programme. Summary information on the portfolio is given below.
Type of security
UK equities
US equities
UK corporate debt
Long-term government debt
Three-month Treasury bonds
Value
£million
23.2
9.4
5.3
11.4
3.2
Average % return
over the last 12 months
15.0
13.5
8.2
7.4
6.0
Approximately 25 per cent of the UK equities are in small companies’ shares, some of them trading on the
Alternative Investment Market. The average return on all UK equities, over the past 12 months, has been
12 per cent. On US equities, it has been 12.5 per cent.
Ignore taxation throughout this question.
Required
Discuss the advantages and disadvantages of holding such a portfolio of investments in the circumstances of
Z plc.
(CIMA, November 1997)
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11
The required rate of return on investment
and Shareholder Value Analysis
Setting the cost of equity
Very few companies are forthcoming about the rate of return they require on investment. The following quotation endures as a remarkably open statement of targets by Quaker Oats Inc. (now part of PepsiCo).
The cost of equity is a measure of the minimum return Quaker must earn to properly compensate investors in
a stock of comparable risk. It is made up of two prime components: the ‘risk-free’ rate and the ‘equity risk premium’. The risk-free rate is the sum of the expected rate of inflation and a ‘real’ return, above inflation, of 2 to
3 per cent. A commonly used surrogate for the risk-free rate is the rate for US Treasury Bonds, which are unconditional obligations of the government intended to pay a real return of 2 or 3 per cent above long-term inflation expectations. For fiscal 1989, the average risk-free rate on these securities was approximately 9 per cent.
For Quaker, a ‘risk premium’ of about 5.3 per cent is added to the risk-free rate to compensate investors
for holding Quaker’s stock, the returns of which depend on the future profitability of the Company. To derive
Quaker’s cost of equity, the risk premium is added to the risk-free rate. In fiscal 1989, the company’s average
cost of equity was approximately 14.2 per cent.
Source: Quaker Inc., Annual Report.
Learning objectives
This chapter applies the models developed in earlier chapters to measuring the required rate of
return on investment projects. After reading it, you should:
■
Understand how the Dividend Growth Model is used to set the hurdle rate.
■
Understand how the Capital Asset Pricing Model is also used for this purpose.
■
Be able to apply the required rate of return to firm valuation.
■
Appreciate that different rates of return may be required at different levels of an organisation.
■
Be aware of the practical difficulties in specifying discount rates for particular activities.
■
Appreciate how taxation may influence discount rates.
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272 Part III Investment risk and return
11.1
INTRODUCTION
The Quaker Annual Report showed the company’s keen appreciation of the need to
reward its shareholders. No company can expect prolonged existence without achieving returns that at least compensate investors for their opportunity costs. Shareholders
who receive a poor rate of return will vote with their wallets, depressing share price. If
its share price underperforms the market (allowing for systematic risk), a company is
ripe for re-organisation, takeover or both. A management team, motivated if only by job
security, must earn acceptable returns for shareholders. This chapter deals with assessing such rates of return and showing how they can be used in valuing firms. Different
returns may be required for different activities, according to their riskiness. Multidivision companies, which operate in a range of often unrelated activities, may require
tailor-made ‘divisional cut-off rates’ to reflect the risk of particular activities.
The return that a company should seek on its investment depends not only on its
inherent business risk, but also on its capital structure – its particular mix of debt and
equity financing. However, because determining this rate for a geared company is
complex, we defer treatment of the impact of gearing until Chapters 19 and 20. Here,
we focus on the return required by the shareholders in an all-equity company.
Shareholders seek a return to cover the cost of waiting for their returns, plus compensation for inflation, plus a premium to cover the exposure to risk of their capital,
depending on the risk of the business activity.
Two widely-adopted approaches are the Dividend Growth Model (DGM), encountered in Chapter 4, and the Capital Asset Pricing Model (CAPM), developed in the last
chapter. Under each approach, we determine the return that shareholders demand on
their investment holdings. We then consider whether this return should dictate the
hurdle rate on new investment projects.
11.2
■
THE REQUIRED RETURN IN ALL-EQUITY FIRMS: THE DGM
The DGM revisited
In Chapter 4, we discussed the value of shares in an all-equity firm which retained a
constant fraction, b, of its earnings in order to finance investment. If retentions are
expected to achieve a rate of return, R, this results in a growth rate of g bR. The share
price is:
Po Do 11 g2
1ke g2
D1
1ke g2
where Do and D1 represent this year’s and next year’s dividends per share respectively,
and ke is the rate of return required by shareholders.
■
The cost of equity
Rearranging the expression, we find the shareholder’s required return is:
ke D1
g
Po
The shareholder’s required return is thus a compound of two elements, the prospective dividend yield and the expected rate of growth in dividends.
It is important to appreciate that this formula for ke is based on the current market
value of the shares, and that it incorporates specific expectations about growth,
dependent on assumptions about both the retention ratio, b, and the expected rate
of return on new investment, R. With b and R constant, the rate of growth, g, is also
constant. These are highly restrictive assumptions. Often, the nearest we can get to
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Chapter 11 The required rate of return on investment and Shareholder Value Analysis
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assessing the likely growth rate is to project the past rate of growth, ‘tweaking’ it if
we believe that a faster or slower rate may occur in future.
For example, assume Arthington plc is valued by the market at £3 per share, having recently paid a dividend of 20p per share, and has recorded dividend growth of 12
per cent p.a. Projecting this past growth rate into the future, we can infer that shareholders require a return of 19.5 per cent, viz:
ke 20 p 11.122
300 p
0.12 10.075 0.122 0.195, i.e. 19.5%
Self-assessment activity 11.1
Determine the required return by shareholders in the following case:
Share price £1.80 (ex div)
Past growth 3%
EPS £0.36
Dividend cover 3 times
(Answer in Appendix A at the back of the book)
■
Whitbread plc
(www.whitbread.co.uk.)
Let us relate this approach to a real company. Table 11.1 shows the dividend payment
record and end-of-financial year share prices for Whitbread, the leisure conglomerate
for the three years 2001/2–2003/4.
The dividend per share (DPS) grew by 25 percent from 17.80p in 2001/2 to 22.30p
by 2003/4. Using discount tables, we find the average annual compound growth
rate is about 12 per cent.* Applying this result to the share price of 741.5p ruling at
Whitbread’s latest year end, we find:
ke 22.30p 11.122
741.5p
0.12 0.033 0.12 0.153 1i.e.2 15.3%.
Table 11.1
Year
The return on
Whitbread plc shares
2001–2
2002–3
2003–4
DPS (p)
17.80
19.87
22.30
Source: Whitbread plc, Annual Report and Accounts.
■
Some problems
Apart from the restrictive assumptions of the dividend growth model, some further
warnings are in order.
*The growth rate, g, is found from the expression:
17.80/(1 g)2 22.30, or (1 g)2 1.2528
The growth rate can be found directly from compound interest tables, or by inverting the expression
from the present value tables, i.e. 1> 11 g2 2 0.7982, whence g approximates to 12 per cent.
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274 Part III Investment risk and return
1 The dividend growth depends on the time period used
A period of just three years, albeit reflecting the most recent dividend record, is really
too short for a reliable growth rate calculation, being subject to random distortions.
There is no ideal period to take – perhaps 5–6 years might be more meaningful.
Unfortunately, the longer the period selected, the greater the likelihood of structural
changes in the business, e.g. major acquisitions and divestments, and/or radical
changes in dividend policy. As it happens, Whitbread fits this profile – in 2000/01, it
paid a dividend of 31.5p per share just prior to selling off its underperforming breweries division. Hence, the dividend has actually fallen over the past few years, as
Whitbread has restructured and moved to a less generous dividend policy.
Nevertheless, it is a progressive one (meaning a growing dividend). It has declared its
aim to move from dividend cover of around 1.7 times to 2.5 times. So long as earnings
carry on rising, so will dividends.
The calculation of g, and hence ke, should be based on a sufficiently long period to
allow random distortions to even out. We may still feel that past growth is an unreliable guide to future performance, especially for a company in a mature industry,
growing roughly in line with the economy as a whole. If past growth is considered
unrepresentative, we may interpose our own forecast, but this would involve secondguessing the market’s growth expectations, which is tantamount to challenging the
EMH.
2 The calculated ke depends on the choice of reference date for measuring
share price
Our calculation used the price at the end of the accounting period, but this pre-dates
the announcement of results and payment of dividend. Arguably, we should use the exdividend price, as this values all future dividends, beginning with those payable in one
year’s time. This would reduce the distortion to share price caused by the pattern of
dividend payment (i.e. the share price drops abruptly when it goes ‘ex-dividend’,
beyond which purchasers of the share will not qualify for the declared dividend).
However, the eventual ex-dividend price may well reflect different expectations from
those ruling at the company financial year end.
Conversely, in an efficient capital market, share prices gradually increase as the
date of dividend payment approaches, so that, especially for companies that pay several dividends each year, some distorting effect is always likely to be present. Our
practical advice is to take the ruling share price as the basis of calculation, but to moderate the calculation according to whether a dividend is in the offing. For example, if
a 5p dividend is expected in two months’ time, a prospective fall in share price of 5p
should be allowed for. In our assessment, the error caused by using an out-of-date
share price is likely to outweigh that from using a valuation incorporating a forthcoming dividend.
3 The calculation is at the mercy of short-term movements in share price
If, as many observers believe, capital markets are becoming more volatile, possibly
undermining their efficiency in valuing companies, the financial manager may feel
disinclined to rely on current market prices. Managers are generally reluctant to
accept the EMH and commonly assert that the market undervalues ‘their companies’. However, there remains a need for a benchmark return to guide managers.
One might examine, over a period of years, the actual returns received by shareholders in the form of both dividends and capital gains. One way of conducting such
a calculation is to focus on average annual rates of return, based on the analysis
adopted in Chapter 10, based on the rather artificial assumption of a one-year holding period. You are advised to re-examine Table 10.1 and to digest the wild swings
in annual returns. These are a clear indication of the risk involved in short-term
equity investment.
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4 Taxation
In Chapter 6, we argued the importance of allowing for taxation in project appraisal
when estimating cash flows. Consistency seems to require discounting post-tax cash
flows at a tax-adjusted cost of finance.
A project’s NPV can be found on a post-tax or a pre-tax basis. If the NPV model is
used on a pre-tax basis, both denominator and numerator must be on a pre-tax basis,
and vice versa. If, for example, we wish to work in post-tax terms, the standard NPV
expression for a one-off end-of-year cash flow, X, is:
NPV X11 T2
11 kT 2
where T is the rate of Corporation Tax and kT is the required return adjusted for tax. If
shareholders seek a return of, say, 10 per cent after tax at 30 per cent, the company has
to earn a pre-tax return of 10%>11 30%2 14.3 per cent. In principle, computation
on a pre-tax basis should generate the same NPV as that produced by a post-tax calculation, so long as the discount rate is suitably adjusted. However, this relationship
is complicated by access to capital allowances. As a result, it is usual to compute NPVs
on a post-tax basis.
The rate of tax applicable to corporate earnings might appear to be the rate of
Corporation Tax. However, the picture is clouded by the prevailing type of tax regime
(e.g. whether classical or an imputation tax system), and by the forms in which shareholders receive income (i.e. the balance between dividend income and capital gains,
and the relevant rates of tax on these two forms of income). In other words, it is important to consider the interaction between the system of corporate taxation and the system of personal taxation.
Under an imputation tax, a shareholder receives a tax credit for the income tax
component incorporated into the profits tax. Shareholders subject to tax at the standard rate face no further tax liability, while higher rate taxpayers face a supplementary tax demand. To add to the complexity, some imputation systems allow investors
to reclaim all the tax paid on their behalf (full imputation), while others involve a
discrepancy between the rate of corporation tax and the relevant rate of income tax
(partial imputation). Since partial imputation applies in the UK, we will consider
only this form.
When we calculated ke using the DGM, the computation was based on the net-oftax dividend payment, so it may appear that we have met the requirement to allow
for taxation. However, the UK tax system imposes two possible tax distortions. First,
the relative tax treatment of capital gains and dividend income has differed over
time, and second, as we have just seen, different shareholders are subject to tax in
different ways.
Regarding the differential tax treatment of dividends and capital gains, a major policy change occurred in 1988. Capital gains achieved after 1982 became taxable at the
same rate as dividends (although with a much higher threshold), thus largely removing the tax penalty on dividends, especially as the top rate of income tax was simultaneously lowered to 40 per cent. Many companies reacted by sharply increasing their
dividend payouts, which distorted the growth pattern of dividends.
A major problem facing a company is divining the tax status of its shareholders.
Inspection of the shareholder register may provide much information, but there is no
easy solution to this problem. The share price is set by the market as a result of the
interaction of the supply and demand for its shares as expressed by thousands of
investors. Although each may well be in a different tax position, the resulting share
price is the result of investors assessing whether the shares represent good value or
not. In other words, the market automatically takes into account the average tax positions of its participants.
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276 Part III Investment risk and return
Under this view, it is not the function of the company to gauge the tax requirements of the investor and to adjust the discount rate accordingly. This is impossible
in a capital market with large numbers of investors. The market imposes a required
return for particular companies, and then it is up to individual investors to make their
own arrangements regarding taxation. The market-determined rate of return can be
regarded as the return that the company must make on its investments. This becomes
the after-tax return that the company should use to discount the after-tax cash flows
from capital projects. (The only adjustment that the company should make is to allow
for the tax shield on debt, as explained in Chapter 18.)
To summarise: in principle, we could discount pre-tax cash flows, but the identification of the appropriate pre-tax required return is complicated by the existence
and timing of capital allowances. Hence, a post-tax computation is preferable.
Theoretically, we ought to allow for investors’ personal tax positions as well as
Corporation Tax (i.e. discount project cash flows net of both Corporation Tax and
investors’ personal tax liabilities). But this requires such detailed knowledge of the
relevant tax rates applicable to shareholders as to render it impracticable. As a result,
it is usual to discount post-Corporation Tax cash flows at the market-expressed
required return, assuming that shareholders have made their own tax arrangements.
This means that shareholders will gravitate to those companies whose dividend
policies most suit their tax positions. This personal clientéle effect is discussed further in Chapter 17.
Self-assessment activity 11.2
Specify the two situations under which the DGM breaks down completely. (You may have
to revisit Chapter 4.)
(Answer in Appendix A at the back of the book)
11.3 THE REQUIRED RETURN IN ALL-EQUITY FIRMS: THE CAPM
In Chapter 10, we saw how the security market line (SML) traces out the systematic
risk–return characteristics of all the securities traded in an efficient capital market. The
SML equation is:
ER j Rf bj 1ER m Rf 2
ER j is the return required on the shares of company j, and is therefore the same as
ke, Rf is the risk-free rate of return, and ER m is the expected return on the market portfolio. We saw in Chapter 10 that, in order to utilise the CAPM, we needed either to
measure or to make direct assumptions about these items. (Refer back to the discussion of measurement difficulties and the application to British Airways.)
However, despite these problems, the CAPM has major advantages over the DGM.
The DGM usually involves extrapolating past rates of growth and accepting the validity of the market’s valuation of the equity at any time. If we suspect that past growth
rates are unlikely to be replicated and/or that a company’s share price is over- or
under-valued, we might doubt the validity of an estimate of ke derived from the DGM.
The CAPM does not require growth projections; nor does it totally depend on the
instantaneous efficiency of the market. Recall that the Beta is derived from a regression model relating the returns from holding the shares of a particular company j to
the returns on the market over a lengthy period. Taking, say, monthly observations
over five years (60 in all) effectively irons out short-term influences. This requires
semi-strong market efficiency for the period and a reasonably consistent relationship
between security returns and the returns on the market portfolios.
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FT
LEX COLUMN
Counting the cost
There are few more essential
items in the corporate finance
tool-kit than a company’s cost
of capital – the return its
investors expect as compensation for putting their funds in
one business rather than
another. Estimating this cost
of capital, however, involves as
much art and guesswork as it
does science, and the results
can vary widely.
Three years ago, those companies that publish a figure for
their cost of capital – usually
those which have adopted a
form of economic profit or economic value added performance framework – often came
out with figures 1–2 percentage points higher than those
implied by market values, or
estimated by stock market
analysts. Today, the gap has in
many cases reversed. Lloyds
TSB, for example, calculates
its economic profit using a cost
of equity of 9 per cent. Yet its
share price appears to imply,
even if you assume it will
halve its dividend, a cost of
equity in excess of 10 per cent.
Why does this matter? To
create value for shareholders,
companies need to make
returns greater than their cost
of capital. If companies are
underestimating cost of capital, they will make acquisitions or invest in projects that
destroy value. Conversely, if
the market is setting the hurdle too high, investors will
miss out on value-creating
investments.
CAPM
Computing the cost of debt is
fairly straightforward, at least
for companies whose bonds are
traded. The cost of equity is
more complicated. The standard formula remains the capital asset pricing model, or
CAPM, devised separately by
William Sharpe, John Lintner
and Jack Treynor. Though many
academic studies have raised
doubts about its empirical validity, three out of four chief financial officers use CAPM.
CAPM’s starting point is the
risk-free rate – typically a 10year government bond yield.
To this is added a premium,
which equity investors require
to compensate them for the
extra risk they accept. This
equity risk premium is multiplied by a factor, known as
beta, to reflect a company’s
volatility and correlation with
the market as a whole. Beta is
designed to capture the risk
that an investor cannot diversify away by holding a portfolio of other shares; a company
whose share price tends to rise
and fall more than the market
will have a high beta. There
are difficulties with all three
of these elements. Government bond yields are currently
very low, by historical standards. A company contemplating a long-term investment
can lock in these low rates for
its debt, but if interest rates
then rise so will its cost of
equity. It may generate the
cash flows it anticipated from
its investment, but these will
no longer cover its cost of capital. It may be appropriate to
use a somewhat higher normalised risk-free rate. Yet it
looks as though many equity
analysts have taken insufficient account of the fall of riskfree rates in their cost of
capital estimates.
The equity risk premium is
the element that has generated
most controversy. In the early
1990s, most companies used
numbers in excess of 6 per
cent, drawing on data from
lbbotson Associates and others. Then market analysts
started to use equity risk premiums of 3–4 per cent and
these numbers began to filter
into corporate use. Historical
performance data compiled by
Elroy Dimson, Paul Marsh and
Mike Staunton give a world
equity premium over bonds of
3.8 per cent over the last 103
years. Marakon Associates, the
strategic consultancy, derives
an equity risk premium of 5.3
per cent, rather higher than
the recent average, from the
implied internal rate of return
of 1,190 stocks, but of 3.6 per
cent on the basis of dividend
yield and growth. Splitting the
difference, that gives an estimate of about 4.5 per cent.
Beta
Beta can be even trickier to
calculate. Ideally, companies
would use a forward looking
beta but estimates depend on
historical trading data. Yet as
McKinsey analysts pointed
out in a recent study, the TMT
bubble of 1998–2001 has dramatically lowered the apparent betas of unaffected sectors.
They calculate an improbably
low current beta of 0.02 for the
food, beverage and tobacco
sector, against an average of
0.85 for 1990–97. Individual
company betas can also deliver
counter-intuitive results. An
accident-prone company may
have a very low beta, because
its mishaps mean it shows less
correlation with the overall
market.
Continued
277
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278 Part III Investment risk and return
Take Allianz as an example:
the German insurer bases its
embedded value calculations
on an 8.15 per cent risk discount rate for Europe and the
US. This is based on a 5 per
cent long-term view of riskfree rates, a 3.5 per cent equity risk premium and a beta of
0.9. This beta, in particular,
might raise an eyebrow, since
the vulnerability of the company’s capital base to equity
market declines would prompt
most investors to call it a
high beta stock. Substituting
a historical German equity
risk premium of 5.7 per cent –
according to Dimson, Marsh and
Staunton – and a Bloombergcalculated beta of 1.14 would
yield a cost of equity of 11.5
per cent.
■
The finer points of CAPM
mattered less when nominal
interest rates were high. Take
a company whose cash flows
are growing at 3 per cent:
using a 12 per cent cost of capital to discount these cash
flows, only one third of its
value lies more than 10 years
out but, at 7 per cent, more
than half is accounted for by
these more distant years.
Small adjustments to the cost
of capital will also have a larger impact on the overall valuation at these lower rates. This
effect weighs even more on
non-financial companies with
a significant amount of debt
on their balance sheets, as
their weighted average cost of
capital will be lower than
their cost of equity.
In most corporate investment decisions, the odd half
point makes little difference,
though in pricing acquisitions
the precise cost of capital may
be more significant. With equity markets still jittery, however, companies are better off
setting a higher hurdle rate for
investment than a straightforward CAPM calculation would
imply. That might not be consistent with academic theory
but it will, in practice, make
them choose more carefully
between their business units
in allocating capital and lead
to less wasteful investment
than in the past.
Source: Financial Times, 24 March 2003.
© Copyright The Financial Times Ltd.
Applying the CAPM to Whitbread plc
The Risk Measurement Service quoted a Beta of 0.96 for Whitbread shares as at
September 2004. In late 2004, the yield on three-month Treasury Bills was 4.75 per cent.
Using a market risk premium of 5 per cent yields the following required return:
ER j Rf b1ER m Rf 2 0.0475 0.9610.052
0.0475 0.048 0.0955 1i.e. 9.6%2
This is considerably below the DGM result. As the two approaches, in principle,
should yield about the same result, some reconciliation is required. At the time of this
calculation, market interest rates were historically low, at least in money terms, generating expectations of low interest rates for the future. It is doubtful whether Whitbread
can sustain 12 per cent divident growth in the future, so it right be more prudent to
use a rate nearer to that of the industry as a whole.
It appears that estimates of ke obtained by either method are susceptible to the date
of the calculation and prevailing expectations for the future. More fundamentally,
whereas the DGM looks at performance over a number of years, the CAPM is essentially a one-period model, although it is commonly used for long-term purposes.
11.4
USING VALUE DRIVERS – SHAREHOLDER VALUE ANALYSIS (SVA)
Now that we know how required rates of return can be estimated, it is appropriate to
show how these can be used in valuation of firms. To achieve this, we draw on the earlier treatment of value drivers and firm valuation in Chapter 4.
As we have observed, in recent years, there has been much greater appreciation of
the need for managers to optimise the interests of shareholders. In general terms, this
can be achieved by generating a rate of return on investment which, at the very least,
matches their required return on investment, i.e. the cost of equity. Remember that
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279
shareholders incur an opportunity cost when subscribing capital for firms to use and
managers are legally obliged to safeguard those funds with all due diligence.
Sometimes, managers feel that ‘their’ companies are not ‘correctly’ valued by the stock
market – there has been a steady trickle of firms de-listing from the main UK market since
the late 1990s, largely for this reason. Moreover, share prices can swing quite violently in
the short term, which tends to undermine managers’ faith in market efficiency. Often
nonplussed by such gyrations, both managers and shareholders may require a more
objective and reliable measure of value than simply the prevailing market price.
Such a measure can be provided by the shareholder value approach, propounded
by Alfred Rappaport, drawing on Michael Porter’s ideas. You met the concept of a
value driver in Chapter 4 – here we make use of this idea to analyse inherent shareholder value (SV), which may be thought of as the fundamental, or inherent, value of
the firm to its owners. The SV figure also provides a cross-check on the market’s current valuation of the company. This may be regarded as a more stable and possibly
more reliable indicator of the fundamental value of the firm that is unaffected by the
short-term vagaries of the market.
The following example of Safa plc is the vehicle for investigating the SVA approach.
But first, a refresher on value drivers may be useful.
Rappaport developed a simple but powerful model to calculate the fundamental
value of a business to its owners by focusing on the key factors that determine firm
value. He identified seven value drivers, comprising three cash flow variables and
four parameters:
■
■
■
■
■
■
■
Sales, and its speed of growth
Fixed capital investment
Working capital investment
Operating profit margin
Tax rate on profits
The planning horizon
The required rate of return
In its simplest form, SVA takes the last four drivers as given, and assumes that
the first three, the cash flow variables, change at a constant rate. The key to the
analysis, as with any budgeting exercise, is the level of sales and the projected rate
of increase. From the sales projections, we can programme the operating profits and
cash flows over the planning horizon and discount at a suitable rate to find their
present value.
In the full model, the value of the firm comprises three elements, the value of the
equity, the value of the debt and the value of any non-operating assets, such as marketable securities. However, to keep the analysis simple, we focus on an all-equityfinanced company with no holdings of marketable assets. In addition, we need to
explain the treatment of investment expenditure. To generate value, firms have to
invest, i.e. to generate future cash flows requires preliminary cash outflows. These
appear to reduce value in the short-term but should generate a more than compensating increase in value via future cash flows.
■
Categories of investment
Investment in working capital, especially inventories, is required to support a
planned increase in sales. Often, companies attempt to apply a roughly constant ratio
of working capital to sales so that a 7 per cent sales increase needs an equivalent
increase in working capital investment. This is called incremental working capital
investment.
Replacement investment is undertaken to make good the wear and tear due to
using equipment, or ‘depreciation’. However, there are phasing issues to consider. In
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280 Part III Investment risk and return
reality, in relation to particular items, the act of replacement is infrequent, occurring in
discrete chunks, whereas depreciation in the accounts is an annual provision, so that
in all but the year of replacement, depreciation will likely exceed replacement expenditure. However, taken in aggregate, and especially for larger firms, replacement may
be closely related to depreciation provisions.
New investment in fixed assets. This has two dimensions. First, if the firm wants
to expand sales of existing products, then, unless it has spare capacity, it will need to
invest in additional capital equipment to support the planned sales increase. Second,
new investment may be undertaken to accompany a major strategic venture such as
the development of a new product, which will also generate an increase in sales. Taken
together, these may be related to the planned sales increase, although there is likely to
be a time lag before strategic investment comes fully ‘on stream’ and is able to deliver
higher sales quantities. Notwithstanding this qualification, we can link the amount of
investment in new capacity, for whatever reason and which adds to the firm’s stock of
assets, to a planned increase in sales. We call the resulting sum the incremental fixed capital investment.
In the following demonstration example of Safa plc, replacement investment is
assumed to equal depreciation provisions (which are treated as part of operating
expenses in accounting statements), and both working capital investment and
incremental fixed capital investment are made a percentage of any planned sales
increase.
11.5
WORKED EXAMPLE: SAFA PLC
The board of Safa plc is concerned about its current stock market value of £95 million,
especially as board members hold 40 per cent of the existing 100 million ordinary shares
(par value £1) already issued. They are vaguely aware of the SVA concept and have
assembled the following data:
Current sales
Operating profit margin*
£100 million
20 per cent
(*After depreciation. On average, depreciation provisions match ongoing investment requirements
and are fully tax-deductible.)
Estimated rate of sales growth
Rate of corporation tax
Long-term debt
Net book value of assets
5 per cent p.a.
30 per cent (with no delay in payment)
zero
£120 million (net fixed assets plus net
current assets)
To support the increase in sales, additional investment is required as follows:
(i) Increased investment in working capital will be 8 per cent of any concurrent sales
increase.
(ii) Increased investment in fixed assets will be 10 per cent of any concurrent sales
increase.
The risk-free rate of interest is 7.6 per cent, Safa’s Beta coefficient is 0.8 and a consensus view of analyst’s expectations regarding the overall return on the market portfolio is 15.6 per cent.
Safa presently pays out 20 per cent of profit after tax as dividend. The board estimate that Safa can continue to enjoy its traditional source of competitive advantage as
a low cost provider for a further six years, at the end of which it estimates the net book
value of its assets will be £140 million.
What is the inherent underlying value of this company?
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281
Answer and comments
First of all, we need to find the return required by the shareholders of Safa, using the
CAPM formula. This is:
ke Rf b 3ER m Rf 4
7.6% 0.8 3 15.6% 7.6% 4
17.6% 6.4%2 14%
ˇ
This becomes the appropriate rate at which to value Safa’s future cash flows.
There is no debt finance so all operating profits (less tax) are attributable to shareholders. There appears to be no long-term strategic investment programme, and
wear-and-tear is made good at a rate roughly corresponding to tax-allowable depreciation provisions. This means that free cash flows are equal to operating profits
less tax.
The firm enjoys a temporary cost advantage for six years, beyond which cash flows
are uncertain. Post-year-six cash flows can be handled in a number of ways:
1 The year six cash flow figure can be assumed to flow indefinitely. This seems quite an
optimistic assumption to make both in relation to Safa plc and also more generally.
2 A view can be taken on the firm’s efforts to restore competitive advantage and some
growth assumption can then be incorporated. Again, this can only be speculative,
as there is no information on this issue.
3 Perhaps the most prudent assumption to make is that the expected year six book
value of assets will approximate to the value of all future cash flows, i.e. the company has no further supernormal earnings capacity. This implies that any subsequent investment has an NPV of zero.
We adopt the third approach mainly for simplicity.
Table 11.2 shows the cash flows over the competive advantage period, years 1–6
inclusive. The base year (year 0) figures are given to establish a reference line from
which future cash flows will grow.
Table 11.2
Cash flow profile1 for
Safa plc (ungeared)
1
2
3
4
5
6
7
1
2
£m
0
Sales
(5% growth)
Operating profit
margin @ 20%2
Taxation @ 30%
Incremental
working capital
investment @ 8%
of sales increase
Incremental fixed
capital investment
@ 10% of sales
increase
Free cash flow
Present value @ 14%
100
20
(6)
1
2
3
4
5
6, etc.
105
110.25
115.76
121.55
127.63
134.00
21
22.05
23.15
24.31
25.53
26.80
(6.30)
(0.40)
(6.62)
(0.42)
(6.95)
(0.44)
(7.29)
(0.46)
(7.66)
(0.49)
(8.04)
(0.51)
(0.50)
(0.53)
(0.55)
(0.58)
(0.61)
(0.64)
13.80
12.11
14.48
11.14
15.21
10.27
15.98
9.46
16.77
8.71
17.61
8.02
Accuracy of figures influenced by rounding errors.
These can be taken as operating cash flows given the assumption that
depreciation replacement investment.
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282 Part III Investment risk and return
■
Valuing Safa plc
Taking firstly the value created over the competitive advantage period:
PV of operating cash flows (line 7) £59.5 m
Second, we add in the estimated residual value, our proxy for all future operating
cash flows:
The PV of the residual value = £140 m PVIF14,6
= £140 m 0.4556 = £63.8
Shareholder Value = £59.50 m + £63.8 m
= £123.3 m
■
A note on taxation – two simplifications
You should appreciate how taxation is being handled in this example. All replacement
investment is treated as being fully tax-deductible in the year of expenditure. This is a
simplification adopted primarily for arithmetic convenience. In reality, the tax relief
will be spread out over time as the firm claims the 25 per cent writing down allowance
(WDA) each year. In addition, we have ignored the tax saving in relation to the 25 per
cent WDA on the incremental fixed capital expenditure.
Correction for the first factor would reduce the valuation simply because delay in
taking the tax relief would lower the PV of the stream of tax savings. On the other
hand, inclusion of the second set of tax savings would raise the SV figure. If you calculate the ‘true’ valuation by allowing for these aspects, you will find a net increase in
the valuation, although the calculation is a little messy.
We now turn to discuss the actual valuation obtained.
■
Commentary
Looking at the figures as calculated, we find, rather alarmingly, that a large proportion
(52 per cent) of the SV is accounted for by the residual value. Moreover, the SV clearly
exceeds market value £95m, itself below the current book value of assets £120m. This
seems to imply that the company might be worth more if it were broken up (although
the resale value of the assets may not fetch book value). It is thus possible that the market is valuing Safa for its break-up potential rather than as a going concern.
This raises the obvious question of why the market should place such an apparently low value on Safa. We can consider some possible reasons for the market undervaluation of Safa.
■
■
■
■
■
■
■
The market may currently apply a higher discount rate, for example, seeking a
higher reward for risk.
The growth estimate may be regarded as optimistic.
The flow of information provided to the market may be inadequate – for example,
if it does have plans for future investment, are these generally known and understood, at least in outline?
Board control – presumably reflecting domination by members of the founding
family – may look excessive. Such enterprises rarely enjoy a good stock market rating, because there is often a suspicion that the interests of family members may be
allowed to dominate those of ‘outside’ shareholders.
The dividend policy may be thought ungenerous – a 20 per cent payout ratio is low
by UK standards, and there appears to be little scope for worthwhile strategic
investment. Retentions may simply be going into cash balances.
There may be doubts about whether Safa can recover some form of competitive
advantage.
The market may be unimpressed with its present cost advantage-based strategy.
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Its gearing – currently, zero – may be thought to be too low. There is no tax shield
to exploit (see Chapter 19).
Whatever the reason(s), there is plenty for the board to consider!
11.6
USING ‘TAILORED’ DISCOUNT RATES
Applying the discount rates derived using the CAPM to investment projects assumes
that new projects fall into the same risk category as the company’s other operations.
This might be a reasonable assumption for minor projects in existing areas and perhaps
for replacements, but hardly seems justifiable for major new product developments or
acquisitions of companies in unrelated areas. If the expected return is positively related to risk, firms that rely on a single discount rate may tend to over-invest in risky projects to the detriment of less risky, though still attractive projects. Many multi-divisional
companies are effectively portfolios of diverse activities of different degrees of risk. The
Beta of the firm as a whole is thus the weighted average of its component activity Betas.
Each division contributes to the firm’s overall business risk in a way similar to that in
which individual shares contribute to the systematic risk of a portfolio of securities. The
dangers of using a uniform discount rate are shown in Figure 11.1.
Figure 11.1 shows the relationship between the rate of return required on a particular
project and that expected on the market portfolio, linked by the Beta. The overall portfolio of company activities may have a Beta of, say, 1.2, which is a weighted average of
the Betas of component activities. For example, activity A has a greater than average
degree of risk, with a Beta of 2.0, and thus a higher than average discount rate would be
applicable when appraising new projects in this area, while the reverse applies for activity B, which has a Beta of only 0.8. Clearly, to appraise all new projects using a discount
rate based on the overall company Beta of 1.2 would invite serious errors. For example,
in area X, application of the uniform discount rate would result in accepting some projects that should be rejected because they offer too low a return for their level of risk,
while in area Y, some worthwhile low-risk projects would be rejected. Firms should use
‘tailor-made’ cut-off rates for activities involving a degree of risk different from that of
the overall company.
Required
return
ER = Rf + b(ERm – Rf)
A
X
Uniform
discount
rate
B
Y
Rf
Figure 11.1
Risk premiums for
activities of varying risk
0
0.8
1.2
Company b
2.0
Activity b
Self-assessment activity 11.3
What are the discount rates applicable to the firm as a whole and activities A and B on Figure
11.1, assuming a risk-free rate of 5 per cent, and a market risk premium of 6 per cent?
(Answer in Appendix A at the back of the book)
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284 Part III Investment risk and return
b of
shares
Remove Impact
of Gearing?
b of company
Asset b/Activity B
b = 1.2
b of Division A
b = 2.0
Figure 11.2
b of
project A1
b of
project A2
b of Division B
b = 0.8
b of
project B1
b of
project B2
The Beta pyramid
Figure 11.2 shows the three levels, or tiers, of risk found in the multi-activity enterprise, each requiring a different rate of return.
In Chapter 19, we will find that there is a fourth tier of risk that uniquely applies to
ordinary shareholders. In a geared firm, that faces financial risk, the returns achieved
by shareholders are more volatile than the firm’s operating cash flows due to the interest payments that must be paid on debt. In response to this higher risk, shareholders
demand a higher return. In other words, the Beta of the shares exceeds the Beta of the
firm’s business activities. To arrive at the activity Beta, we would need to ‘ungear’ the
Beta of the shares.
If the company is entirely equity-financed, the risks that shareholders incur coincide with those incurred by the company as a whole, i.e. those related to trading and
operational factors. In this case, the Beta of the ordinary shares coincides with that of
the company itself.
Many companies are structured into separate strategic sub-units or divisions,
organised along product or geographical lines. In such companies, it is unlikely that
every activity faces identical systematic risk. So different discount rates should be
applied to evaluate ‘typical’ projects within each division.
However, even within divisions, rarely do two projects have identical risk. Hence,
different discount rates are required when new projects differ in risk from existing
divisional activities.
Segmental Betas
The company Beta is a weighted average of component divisional Betas. For a company with two divisions, A and B, the overall Beta is a weighted average given by:
Company b ¢bA VB
VA
≤ ¢bB ≤
VA VB
VA VB
where the weights represent the proportion of company value accounted for by each segment. A similar expression would apply for each division, where the corresponding
weights would represent the contribution to divisional value accounted for by each component activity. Figure 11.2 illustrates these concepts in the form of a ‘Beta pyramid.’
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Self-assessment activity 11.4
What is the company Beta for the firm shown in Figure 11.1 if activities A and B constitute 65 per cent and 35 per cent of its assets respectively?
(Answer in Appendix A at the back of the book)
Let us use Whitbread plc to illustrate the derivation of the appropriate discount rate
at different levels of an organisation. It is organised into three broad product division
lines, as shown in Table 11.3, which lists the three operating divisions. These titles suggest quite different activities, although a firm’s own description of its division is not
always a reliable guide to the nature of those activities.
We performed a CAPM calculation earlier in relation to the equity of Whitbread,
obtaining a result of 9.6 per cent. Should we apply this rate to all investments undertaken by Whitbread? The answer is ‘no’, if we believe there are risk differences
between the divisions, in which case, we should calculate tailor-made discount rates.
Table 11.3
Divisional Betas for
Whitbread plc
Activity
% share of sales
Surrogate company
Beta
Weighted
beta
Hotels
33%
Millennium and
Capthorne
1.1
0.363
Pubs and
restaurants
56%
J.D. Wetherspoon
0.84
0.470
Sports, health
and fitness
11%
Springhealth Leisure
0.89
0.098
Totals
100
0.931
Source: Whitbread plc Report and Accounts, Risk Measurement Service (RMS), September–December 2004.
■
The divisional cut-off rate
pure play technique
Adoption of the Beta value of
another firm for use in evaluating investment in an
unquoted entity such as an
unquoted firm, or a division of
a larger firm
We need now to consider what are suitable Betas for the three Whitbread divisions.
However, no Betas are recorded for company divisions, simply because no market
trades securities representing title to a firms’ divisional assets. Instead, we need to look
for three surrogate companies and use their ungeared Betas as the ‘stand-in’ estimates
for the Betas of the three Whitbread divisions. This involves using what Fuller and Kerr
(1981) called the pure play technique. It relies on the principle that: ‘the risk of a division of a conglomerate company is the same as the risk of an undiversified firm in the
same line of business (adjusted for financial risk)’.
Consulting the RMS, we look for suitable surrogate companies whose Betas we can
use as proxies for those of the Whitbread divisions. The dangers of doing this should
not be understated. Ideally, the surrogate should be a close match for the relevant
Whitbreads division, i.e. they should conduct the same activity or mix of activities in
the same proportions, and should also be ungeared. (If they use debt finance, the gearing effect on their Betas should be stripped out, as explained in Chapter 19.) In principle, the weighted averages of these Beta values will coincide with the overall Beta of
Whitbread plc if we have selected good surrogates. The weightings ought to be based
on market values, but as these are unknown for company divisions, book values of net
operating assets could be used. Not all companies reveal divisional asset values, so a
proxy measure such as sales or operating profits may have to be used. For Whitbread,
share of sales has been used.
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286 Part III Investment risk and return
Table 11.3 shows that the weighted average Beta for Whitbread is 0.93, a shade
below the value of 0.96 given in the RMS. The discrepancy could be due to the following reasons:
■
■
■
The chosen surrogates are not close enough matches for Whitbread’s array of
activities.
Differences in gearing. As we will see in a later chapter, gearing has the effect of
raising Beta values as shareholders seek an extra premium to compensate for the
financial risk that gearing imposes. The RMS Beta values are all equity Betas – they
include the effect of gearing, and, of course, different firms may have different gearing ratios. Hence, if we take a Beta from a low-geared firm and apply it to a highgeared one, our weighted average calculation will understate the true Beta of the
focus firm, and vice versa. Ideally, we should compare like with like, either strip out
the effect of gearing altogether, and work in terms of pure equity (or activity) Betas,
or ungear the Betas of the surrogates, and then re-gear them to reflect the gearing
of the focus firm. These issues we defer to Chapter 19.
The project cut-off rate
If any division undertakes a new venture that takes it outside its existing risk parameters, clearly we must look for different rates of return – in effect, we need to obtain estimates for individual project Betas. Without access to internal records, our analysis can
only be indicative, but the following principles offer broad guidance.
Essentially, we look for sources of risk that make the individual project more or less
chancy relative to existing operations. There are two broad reasons why projects have
different risks to the divisions where they are based – different revenue sensitivity and
different operating gearing.
■
Revenue sensitivity
Imagine Whitbread is looking at developing a new restaurant brand. The sales generated by the projected facility may vary with changes in economic activity to a greater
or lesser degree than existing sales in the relevant division. For example, we may expect
that, for a specified rise in the level of GDP, whereas overall retail sales of Whitbread
existing restaurants increase by 7 per cent, the sales of the new brand rise by 9 per cent.
■
The revenue sensitivity factor
revenue sensitivity factor
The sensitivity to economic
fluctuations of a project’s sales
in relation to that of the division to which it is attached
This magnifying effect is measured by the revenue sensitivity factor (RSF). The RSF is
calculated as follows:
RSF Sensitivity of project sales to economic changes
Sensitivity of divisional sales to economic changes
9%
1.29
7%
This relationship may stem from the nature of the product – if it is pitched at discretionary spenders (e.g. people who frequent more ‘upmarket’ outlets), it may be
more closely geared to the economy as a whole.
■
Operating gearing
This concerns the extent to which the project cost structure comprises fixed charges.
The higher the proportion of fixed costs in the cost structure, the greater the impact of
a change in economic conditions on the operating cash flow of the project, thus magnifying the revenue sensitivity effect. Again, the project may exhibit a degree of operating gearing different from that of the division as a whole.
To illustrate the impact of operating gearing, consider the figures in Table 11.4,
where the firm applies a 50 per cent mark-up on variable cost. An increase in sales
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Table 11.4
The effect of operating
gearing (£m)
project gearing factor
The proportionate increase in a
project’s operating cash flow in
relation to a proportionate
increase in the project’s sales
operating gearing factor
The operating gearing factor of
an individual project in relation
to that of the division to
which it is attached
■
Sales revenue
Variable costs
Fixed cash costs
Operating cash flow
90
60
60
40
5
5
25
15
revenue of 50 per cent will lead to an increase in net operating cash flow of 67 per cent
because of the gearing effect. There is thus a magnifying factor of 1.34. This so-called
project gearing factor (PGF) may well differ from the gearing factor(s) found elsewhere in the division.
To measure the relative level of gearing, the operating gearing factor (OGF) is used.
This is defined as:
OGF Project gearing factor
Divisional gearing factor
If the divisional gearing factor is 1.80, for example, the project’s OGF 1.34>1.80 0.74.
The second step in assessing the project discount rate brings together these two
sources of relative project risk into a project risk factor (PRF).
The project risk factor
This is the compound of the revenue sensitivity factor and the operating gearing factor:
Project risk factor RSF OGF
In our example, this is equal to 11.29 0.742 0.95. In this case, the project is less
risky than the ‘average’ project within the division and merits the application of a
lower Beta. Based on the Whitbread pubs and restaurant Beta, shown in Table 11.3, this
is given by:
Project Beta 10.95 0.842 0.80
The final step calculates the required return using the basic CAPM equation, based
on a 4.75 per cent risk-free rate and a market risk premium of 5 per cent:
Required return 0.0475 0.8010.052 0.0475 0.04 0.875 1i.e. 8.8% 2
Self-assessment activity 11.5
Determine the required return on a project whose revenue sensitivity is 50 per cent and
operating gearing 80 per cent compared to the division where it is located. The divisional
Beta is 1.2, the risk-free rate is 5 per cent and the market risk premium 6 per cent.
(Answer in Appendix A at the back of the book)
■
Project discount rates in practice
Considering the informational requirements for obtaining reliable tailor-made discount
rates for particular investment projects, few firms go to these lengths. A far more common practice is to seek an overall divisional rate of return, which becomes the average
cut-off rate, but is then adjusted for risk on a largely intuitive basis, according to the
perceived degree of risk of the project. For example, many firms group projects into
‘risk categories’ such as the classification in Table 11.5. For each category, a target or
required return is established as the cut-off rate.
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288 Part III Investment risk and return
Table 11.5
Subjective risk
categories
Project type
Replacement
Cost saving/application of advanced manufacturing technology
‘Scale’ projects, i.e. expansion of existing activities
New project development:
Imitative products
Conceptually new products, i.e. no existing competitors
Required return (%)
12
15
18
20
25
Imagine the divisional required return is 18 per cent, the rate applicable to projects
that replicate the firm’s existing activities. Around this benchmark are clustered activities of varying degrees of risk, and as the perceived riskiness increases, the target
return rises in tandem.
In all these cases, we are discussing a discount rate derived from the ungeared Beta.
In other words, we are separating out the inherent profitability of the project from any
financing costs and benefits. Analysis of financing complications is deferred to
Chapters 18 and 19.
11.7
ANOTHER PROBLEM: TAXATION AND THE CAPM
Empirical studies of the risk premium usually reveal gross-of-personal-tax results. To
adjust for tax, one might consider the tax status of interest income from the risk-free
asset, normally taken as government stock of some form, and the tax status of the
return on the market portfolio.
Franks and Broyles (1979) recommended two adjustments. First, adjust the risk-free
rate for the shareholders’ rate of personal tax (at present, UK basic-rate tax on interest
income is 20 per cent), then adjust the risk premium according to the relative proportions of excess return earned in dividends and in capital gain form. Grubb (1993/4)
shows that over 1960–92, about half of the return on equities was from dividends and
half from capital gain. Two major problems follow. Capital Gains Tax (CGT) was only
introduced in 1965, and has been applied at varying rates, while the basic rate of
income tax has also changed many times over this period. Moreover, in reality, very
few shareholders are liable to CGT. However, taking 20 per cent as an average rate of
CGT and 25 per cent as an average rate of tax on dividends thus yielding a weighted
average tax rate (WAT) of 10.5 0.202 10.5 0.252 22.5%, the calculation of the
post-tax required return on Whitbread’s ordinary shares 1ER W 2 would be:
ER W Rf 11 present income tax rate2 b 3 market risk premium 4 3 1 WAT 4
0.047511 0.22 0.96 30.054
0.038 0.037
0.075 i.e. 7.5%
There are obvious problems in taking average rates of tax over periods when tax
regimes have altered. Wilkie (1994) argues that such a calculation is conceptually
flawed, being based on the assumption that individuals would have invested in a taxinefficient vehicle (government stock) – although many do! Most personal investors
would have been subject to higher rates of income tax and thus would have taken
steps anyway to shelter their income from tax. Finally, he points out that the securities
market historically has been dominated by tax-exempt investors, in terms of both the
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percentages of share value held and, more crucially, the flow of new funds to the market, which dictates market prices. He concludes that little accuracy is lost by using the
gross-of-tax risk premium, and ignoring any tax effect on the risk-free rate, especially
as future tax rates on investment income are likely to be lower than past rates, following widespread tax cuts in the 1990s.
This view is very appealing, both in view of the rapid growth in the popularity of
tax breaks like the old TESSAs and PEPs, and now ISAs; and also for simplicity.
Difficulties over specifying discount rates may go some way to explaining the continuing popularity of the payback method. Significantly, this is usually used in conjunction with the IRR, which does not require the pre-specification of a discount rate. This
combination becomes a convenient means of communicating criteria of investment
acceptability throughout a company without requiring continuous updating of the
discount rate for the tax position. A survey of over 200 firms conducted for the CBI by
Junankar (1994) found that 56 per cent of those that used the IRR method applied it on
a pre-tax basis.
11.8
PROBLEMS WITH ‘TAILORED’ DISCOUNT RATES
The pure play technique is an appealing device for estimating discount rates for specific activities, but suffers from a number of practical difficulties.
1 Selecting the proxy. To select a proxy, the firm needs to examine the range of apparently similar candidates operating in the relevant sector. However, no two companies have the same business risk due to diversity of markets, management skills
and other operating characteristics. How one chooses between a range of ‘fairly
similar’ candidates is essentially an issue of judgement.
2 Divisional interdependencies. In practice, it is difficult to make a rigid demarcation
of divisional costs and incomes, since most divisionalised companies share facilities, ranging from the highest decision-making level to joint research and development, joint distribution channels and joint marketing activities. Indeed, access
to shared facilities often provides the initial motive for forming a diversified conglomerate, enabling the elimination of duplicated services and the exploitation
of scale economies. If carefully evaluated and implemented, the merging of activities should create value and reduce business risk. Only when a merger has no
operating impact across divisional lines can it be suggested that business risk
itself is unaffected. Even so, there may well be synergies at the peak decisionmaking level.
3 Differential growth opportunities. Using a cut-off rate based on another firm suggests
that the division in question has the same growth prospects as the surrogate.
However, opportunities to grow are determined by dividend policy, the extent of
capital rationing and the interaction between divisions, e.g. competition for scarce
investment capital. In reality, because the firm’s own decision processes help to
determine the potential for growth, it is not accurate to assume that growth opportunities are externally derived.
4 Joint ventures. The use of differential discount rates may destroy the incentive to
cooperate on projects that straddle divisional boundaries. For example, a joint
venture whose expected return lies between the cut-off rates of the two divisions will be attractive to one and unacceptable to the other. Here, some form of
mediation is required at peak level, which reassures the ‘loser’ of the decision
that subsequent performance will be assessed after adjusting for having to operate with a project that it did not want, or without a project that it did wish to
undertake.
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290 Part III Investment risk and return
11.9
A CRITIQUE OF DIVISIONAL HURDLE RATES*
Modern strategic planning has moved away from crude portfolio planning devices
such as the Boston Consulting Group’s market share/market growth matrix towards
capital allocation methods that emphasise the creation of shareholder value. Central to
value-based approaches is discounting projected cash flows to determine the value to
shareholders of business units and their strategies. A key feature of the DCF approach is
the recognition that different business strategies involve different degrees of risk and should be
discounted at tailored risk-adjusted rates.
However, critics such as Reimann (1990) suggest that differential rates will increase
the likelihood of internal dissension, whereby a manager of a ‘penalised’ division
may resent the requirement to earn a rate of return significantly higher than some of
his colleague-competitors. This resentment may be worsened by the observation that
longer-term developments, especially in advanced manufacturing technology and
other risky, but potentially high value-added activities, may be ‘unfairly’ discriminated against. As a result, managers may be reluctant to propose some potentially
attractive projects.
As we saw in Chapter 8, risk-adjusted discount rates have the effect of compounding risk differences, making ostensibly riskier projects appear to increase in risk over
time. One school of thought contends that in order to avoid this risk penalty, the
attempt to tailor discount rates to divisions should be modified, if not abandoned. For
example, instead of using differential discount rates, firms might use a more easily
understood and acceptable, company-wide discount rate for projects of ‘normal’ risk,
but appraise high-risk/high-return projects using different approaches.
Underlying these arguments is the familiar assertion that diversification by firms
differs crucially from shareholder diversification, so that applying the CAPM to the
former could be misleading. If an investor adds a new share to an existing portfolio,
the market risk of the portfolio will alter according to the Beta of the new security. If
its Beta is higher than that of the existing portfolio, then the portfolio Beta increases,
and vice versa. With corporate diversification, however, we are not dealing with a basket of shares of unrelated companies, which may be freely traded on the market. A
firm that diversifies rarely adds totally unrelated activities to its core operations. It
may add value if the new activity possesses synergy, or detract from value if the market views the combination as merely a bundle of disparate, unwieldy activities that are
hard to manage.
Market risk can be altered by strategic diversification decisions at two levels. At the
corporate level, decisions concerning business and product mixes, and operating and
financial gearing can affect market risk. The effect of both types of gearing can be magnified by the business cycle, so that a firm which engages in contra-cyclical diversification may dampen oscillations in shareholder returns and thus reduce market risk.
At the business level, market risk can be reduced by tying up outlets and supplier
sources (i.e. by increasing market power), and by developing business activities that
enjoy important interrelationships, such as common skills or technologies (i.e. by
exploiting economies of scale).
Many managers feel that the emphasis on hurdle rates is probably misplaced insofar as accurate cash flow forecasts are more important to creating business value than
the particular discount rate applied to them. This probably helps explain the continuing popularity of the payback method, and the reluctance, at least in the UK, to adopt
CAPM-based approaches. It may also explain why so many successful firms place
great emphasis on post-auditing capital projects in order to sharpen up the cash flow
forecasting and project appraisals of subordinate staff. Furthermore, there is evidence
*This section relies heavily on arguments used by Reimann (1990).
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(Pruitt and Gitman, 1987; Pohlman et al., 1988) that senior managers manifest their suspicion of subordinates’ cash flow predictions by deflating the figures presented to
them when projects are submitted for approval.
In view of these arguments, there may be a case for reconsidering the merits of
using certainty equivalents – adjusting the cash flow estimates and then discounting
at the risk-free rate. However, this has not been widely adopted. Apart from the difficulty of specifying the risk-free asset, there is the problem of determining the certainty equivalent factors, which involves specifying the probabilities of different possible
cash flows as a basis for assessing their utility values. While techniques are available
for doing this (Swalm, 1966; Chesley, 1975), it has not been practicable in most firms.
Reimann (1990) suggests a ‘management by exception’ approach. The firm should
establish and continuously update a corporate cost of capital, based on CAPM principles. This should be applied as a common hurdle rate for the majority of business
activities, which, he argues, typically exhibit very similar degrees of risk. At the business level, major emphasis should be given to careful cash flow estimation, based on
evaluation of long-term strategic opportunities and competitive advantage. A key element should be a multiple scenario approach, whereby the implications of ‘best’,
‘worst’ and ‘most likely’ states of the world are examined. For projects that, by their
very nature, have a demonstrably greater level of risk, other procedures may be appropriate. Rather than adjust the corporate discount rate, Reimann suggests the risk adjustment be made to the cash flow estimates by the business unit executives themselves, i.e.
those with closest knowledge both of the market and of competitors’ behaviour patterns. Again, a multiple scenario approach should be adopted. This avoids the effect of
compounding risk differences over time and thus penalising longer-term projects,
which may have a demotivating effect on staff engaged in pursuing high-risk activities.
This discussion may seem to downgrade the importance of DCF and CAPM
approaches in project appraisal. However, it is really intended to remind you that
apparently neat mathematical models rarely hold the whole answer. If the rigid application of a numerical routine leads managers to question the basis of the routine itself
(one which we believe offers powerful guidance in many situations) and to exhibit
dysfunctional behaviour, it is far better to modify the routine itself to reflect real world
practicalities.
SUMMARY
We have considered the relative merits of using the DGM and the CAPM to derive the
rate of return required by shareholders. The case for and against using tailor-made discount rates for particular business segments and projects was also discussed.
Key points
■
The return required on new investment depends primarily on two factors: degree
of risk and the method of financing the project.
■
In ungeared companies, the return required by shareholders can be estimated using
either the DGM or the CAPM.
■
The DGM relies on several critical assumptions: in particular, sustained and constant growth, and the instantaneous reliability of the share price set by the market.
■
The CAPM relies on a Beta estimate obtained after smoothing short-term distortions, but the estimated ke may be affected by random influences on the risk-free
rate.
Continued
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292 Part III Investment risk and return
■
Application of a uniform company-wide discount rate to all company projects can
lead to accepting projects that should be rejected and to rejecting projects that
should be accepted.
■
To resolve the problem of risk differences between divisions of a company, the Beta of
a surrogate firm (adjusted for gearing) can be used to establish divisional cut-off rates.
■
If individual projects within the division also differ in risk, the divisional Beta can be
adjusted for differences in revenue sensitivity and/or differences in operating gearing.
■
Not all academics and business people accept the need to define discount rates so
carefully, preferring instead to concentrate on the problems of cash flow estimation.
■
Reimann argues that a divisional cut-off rate should be used as a rough benchmark
for projects, but alternative methods of risk analysis should be applied to explore
more fully the risk characteristics and the acceptability of investment proposals.
Further reading
Analyses of the ‘tailored’ discount rate can be found in Dimson and Marsh (1982) and Andrews
and Firer (1987). Gup and Norwood (1982) and Harrington (1983) provide practical illustrations
of how US corporations apply divisional discount rates, while Reimann (1990) gives a critique of
the whole approach.
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QUESTIONS
Questions with a coloured number have solutions in Appendix B on page 701.
1 The ordinary shares of Rasal plc have a market price of £10.50, following a recent dividend payment of £0.80
per share. Dividend growth has averaged 4.5 per cent p.a. over the past five years. What is the rate of return
required by shareholders implied by the current share price?
2 Insert the missing values in the following table:
ke
(i) 11%
(ii) 14%
(iii) ?
(iv) 12%
Po
g
Do
£8.00
?
£5.00
£4.60
3%
4%
6%
?
?
£0.350
£0.155
£0.250
3 Lofthouse plc has paid out dividends per share over the past few years, as follows:
1996
1997
1998
1999
2000
11.0p
12.5p
14.0p
17.0p
20.0p
In March 2000, the market price per share of Lofthouse is £5.00 ex-dividend. What is the rate of return required
by investors in Lofthouse’s equity implied by the Dividend Growth Model?
4 The all-equity financed Lasar plc has a Beta of 0.8. What rate of return should it seek on new investment:
(i) with similar risk to existing activities?
(ii) with 25 per cent greater risk compared to existing activities?
(iii) with 25 per cent lower risk compared to existing activities?
The risk-free rate of interest is 6 per cent, and the expected return on the market portfolio is 11 per cent.
5 Salas Ltd is an unquoted company that operates four divisions, all focused on single activities as shown in the
table below. Salas identifies a proxy quoted company for each activity in order to calculate cut-off rates for
new investment.
Division
Construction (C)
Engineering (E)
Road Haulage (R)
Packaging (P)
Proxy beta
Assets employed (£m)
0.7
1.1
0.8
0.6
3.00
8.00
4.00
5.00
The risk-free rate is 7 per cent, and the expected return on the market portfolio is 15 per cent.
Required
(i) Calculate the required return at each division.
(ii) Calculate Salas’ overall required rate of return.
6 Megacorp plc, an all-equity financed multinational, is contemplating expansion into an overseas market. It is
considering whether to invest directly in the country concerned by building a greenfield site factory. The
expected payoff from the project would depend on the future state of the economy of Erewhon, the host country, as shown below:
Continued
293
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294 Part III Investment risk and return
State of Erewhon economy
Probability
IRR from project (%)
0.1
0.2
0.5
0.2
10
20
10
20
E1
E2
E3
E4
Megacorp’s existing activities are expected to generate an overall return of 30 per cent with a standard deviation of 14 per cent. The correlation coefficient of Megacorp’s returns with that of the new project is 0.36,
Megacorp’s returns have a correlation coefficient of 0.80 with the return on the market portfolio, and the new
project has a correlation coefficient of 0.10 with the UK market portfolio.
■
■
■
■
The Beta coefficient for Megacorp is 1.20.
The risk-free rate is 12 per cent.
The risk premium on the UK market portfolio is 15 per cent.
Assume Megacorp’s shares are correctly priced by the market.
Required
(a) Determine the expected rate of return and standard deviation of the return from the new project.
(b) If the new project requires capital funding equal to 25 per cent of the value of the existing assets of
Megacorp, determine the risk–return characteristics of Megacorp after the investment.
(c) What effect will the adoption of the project have on the Beta of Megacorp?
Ignore all taxes.
7 PFK plc is an undiversified and ungeared company operating in the cardboard packaging industry. The Beta
coefficient of its ordinary shares is 1.05. It now contemplates diversification into making plastic containers.
After evaluation of the proposed investment, it considers that the expected cash flows can be described by the
following probability distribution:
State of economy
Probability
Internal rate of return (%)
0.2
0.3
0.3
0.2
5
8
12
30
Recession
No growth
Steady growth
Rapid growth
The overall risk (standard deviation) of parent company returns is 20 per cent and the risk of the market
return is 12 per cent. The risk-free rate is 5 per cent and the FTSE-100 Index is expected to offer an overall return
of 10 per cent per annum in the foreseeable future.
The new project will increase the value of PFK’s assets by 33 per cent.
Required
(a) Calculate the risk–return characteristics of PFK’s proposed diversification.
(b) It is believed that the plastic cartons activity has a covariance value of 40 with the company’s existing
activity.
(i) Calculate the total risk of the company after undertaking the diversification.
(ii) Calculate the new Beta value for PFK, given that the diversification lowers its overall covariance with
the market portfolio to 120.
(iii) Deduce the Beta value for the new activity.
(iv) What appears to be the required return on this new activity?
(c) Discuss the desirability, from the shareholders’ point of view, of the proposed diversification.
You may ignore taxes.
8 Lancelot plc is a diversified company with three operating divisions – North, South and West. The operating
characteristics of North are 50 per cent more risky than South, while West is 25 per cent less risky than South.
In terms of financial valuation, South is thought to have a market value twice that of North, which has the
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Chapter 11 The required rate of return on investment and Shareholder Value Analysis
same market value as West. Lancelot is all-equity-financed with a Beta of 1.06. The overall return on the FT
All-Share Index is 25 per cent, with a standard deviation of 16 per cent.
Recently, South has been under-performing and Lancelot’s management plan to sell it and use the entire
proceeds to purchase East Ltd, an unquoted company. East is all-equity-financed and Lancelot’s financial
strategists reckon that while East is operating in broadly similar markets and industries to South, East has a
revenue sensitivity of 1.4 times that of South, and an operating gearing ratio of 1.6 compared to the current
operating gearing in South of 2.0.
Assume: no synergistic benefits from the divestment and acquisition. You may ignore taxation.
Required
(a) Calculate the asset Betas for the North, South and West divisions of Lancelot. Specify any assumptions
that you make.
(b) Calculate the asset Beta for East.
(c) Calculate the asset Beta for Lancelot after the divestment and acquisition.
(d) What discount rate should be applied to any new investment projects in East division?
(e) Indicate the problems in obtaining a ‘tailor-made’ project discount rate such as that calculated in section (d).
Note: More questions on required rates of return can be found in Chapter 19, where the additional complexities of gearing are discussed.
295
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12
Identifying and valuing options*
The marriage (option) contract
‘Wilt thou have this woman to be thy lawful wedded
wife?’ As the minister posed this question, the groom,
a highly trained financial analyst, reflected that marriage bore many characteristics of the investment
decisions he faced every day. It was clearly a longterm commitment, involving uncertain costs and
benefits. What is more, it was largely irreversible; and
the abandonment option of divorce was too costly
and painful to contemplate. The follow-on option was
interesting. How many kids had she mentioned?
But what about the options he would be sacrificing? The option to remain an independent bachelor,
or the option to wait another six months to be better
informed as to whether the couple were really right
for each other. Just how valuable was the marriage
option contract, and was now the right expiry date?
After a moment’s hesitation, the groom turned
and looked into his bride’s adoring eyes. All thoughts
of rational economic analysis and option theory
evaporated as he found himself saying, ‘I will’.
Learning objectives
By the end of this chapter, you should possess a clear understanding of the following:
■
The basic types of option and how they are employed.
■
The main factors determining option values.
■
How options can be used to reduce risk.
■
How option values can be estimated.
■
The various applications of option theory to investment and corporate finance.
■
Why conventional net present value analysis is not sufficient for appraising projects.
*The authors are grateful for the contribution to this chapter by Andrew Marshall.
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Chapter 12 Identifying and valuing options
12.1
INTRODUCTION
’underlying’ asset
The asset from which option
value is derived
12.2
297
Business managers like to ‘keep their options open’. Options convey the right, but not
the obligation, to do something in the future. Like getting married, most business decisions involve closing off certain options while opening up others. Managers should
seek to create capital projects or financial instruments with valuable options embedded
in them. For example, an investment proposal will be worth more if it contains the flexibility to exit relatively cheaply should things go wrong. This is because the ‘downside’
risk is minimised. Often it is not possible, or too costly, to build in such options.
However, the financial manager can achieve much the same effect by creating options
in financial markets.
Options are derivative assets. A ‘derivative’ is an asset which derives its value from
another asset. The primary asset is referred to as the ‘underlying’ asset. Option-like features occur in various aspects of finance, and option theory provides a powerful tool
for understanding the value of such options.
This chapter concludes Part III of this book, on handling risk in investment decisions, by examining the nature and types of options available and how they can reduce
risk or add value. It also explains why the conventional net present value approach
may not tell the whole story in appraising capital projects.
SHARE OPTIONS
In finance, options are contractual arrangements giving the owner the right, but not the obligation, to buy or sell something, at a given price, at some time in the future. Note the two key
elements in options: (1) the right to choose whether or not to take up the option, and
(2) at an agreed price. It is not a true option if I am free to buy in the future at the prevailing market price, or if I am compelled to buy at an agreed price. Many securities have
option features: for example, convertible bonds and share warrants, where options to
convert to, or acquire, equity are given to the owner.
■
Share options in Enigma Drugs plc
The simplest form of share option is when a company issues them as a way of rewarding employees. If the current share price of Enigma Drugs plc is £4, it might award
share options to some of its employees at, say, the same price. If, over the period in
which the shares can be exercised, the shares go up, employees could then purchase
shares at a price below market price either to sell at a profit or gain an equity interest.
Most options relate to assets which already exist. These are termed pure options. To
begin with, we will consider pure share options, although much of our analysis could
apply equally to interest rates, currency, oil and commodity markets. But first we need
to go back to basics. Figure 12.1(a) depicts the payoff line for investing in ordinary
shares in Enigma Drugs plc. If the shares are bought today at 400p, the payoff, or gain,
from selling at the same price is zero. If, say, three months later, the share price has
risen to 450p, the payoff is 50p; but if it has dropped to 350p, the payoff is 50p. The
line is drawn at 45 degrees because a 50p increase in share price from its current level
of 400p gives a 50p payoff.
We have all seen the warnings accompanying advertisements for financial products, reminding us that share prices can go up or down. But wouldn’t it be nice if,
whichever way prices moved, you ended up a winner? This can be done if you also
acquire share options. With options you can create a ‘no lose’ option strategy providing protection from a drop in share price, as shown in Figure 12.1(b). The arrowed line
represents the payoff from the option to buy shares. If share price increases, so does
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Figure 12.1
Payoff lines for shares
and share options in
Enigma Drugs plc
(underlying share price
is blue, option contract
is red)
Payoff (pence)
Payoff (pence)
Payoff (pence)
298 Part III Investment risk and return
+ 50
(a) Share price movements over
time. The underlying share price
can move up or down
0
350
400
450
− 50
Share price
(pence)
+ 50
0
350
400
450
− 50
+50
0
350
400
450
(b) Option to buy shares. By
entering into an option contract,
any downward risk below current
Share price
price can be protected
(pence)
(c) Option to buy and sell
shares. With this option strategy
the payoff is positive whichever
way the share price moves
Share price
(pence)
the option payoff. But if the share price falls below 400p, to say 350p, the option payoff remains at zero.
By combining different types of option you can even create a ‘win–win’ situation.
For example, Figure 12.1(c) shows the effects of combining options to buy and sell
shares at a fixed price. Here, either a rise or a fall in share price gives you a positive
payoff. At this stage, however, you do not need to know how this is achieved, simply
that it can be done. Of course, few things in life are free and a share option is not one
of them (unless they form part of a remuneration package). Later we will show how
to value such options.
■
Issuing options
Options on shares are not issued by the companies on whose shares they are written
but by large financial institutions, such as insurance companies. The companies play no
role in the issuing process. For the institutions issuing options the primary motivation
is the fee income that their sale generates, but some also use options in their portfolio
of management activities to limit their risk exposure.
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Chapter 12 Identifying and valuing options
traditional options
An option available on any
security agreed between buyer
and seller. It typically lasts for
three months
traded options
An option traded on a market
299
Considerable interest has developed in recent years in share options, and there is a
highly active market on the Stock Exchange for traditional and traded options.
Traditional options are available on most leading shares and last for three months. A
problem with these is that they are not particularly flexible or negotiable: investors
must either exercise their option (i.e. buy or sell the underlying share) or allow it to
lapse; they cannot trade their option.
To overcome these difficulties, Traded options markets were established, first in
Chicago, then in Amsterdam (the European Options Exchange). In 1978 the London
Traded Options Market was established for major companies, now part of the London
International Financial Futures and Options Exchange (LIFFE) (see www.liffe.com).
An exchange traded contract is characterised by certain standardised features, particularly the exercise date and the exercise price. This makes it far easier to develop a
continuous market in options than was the case for traditional options that were
developed and traded on an ad hoc basis.
Options terminology
This topic has more than its fair share of esoteric jargon, some of the more essential of which
are defined below.
option contract
A contract giving one party
the right, but not the obligation, to buy or sell a financial
instrument or commodity at
an agreed price at or before a
specified date
exercise price
Price at which an option can
be taken up
■
A call option gives its owner the right to buy specific shares at a fixed price – the exercise
price or strike price.
■
A put option gives its owner the right to sell (put up for sale) shares at a fixed price.
■
A European option can be exercised only on a particular day (i.e. the end of its life), while
an American option may be exercised at any time up to the date of expiry. These terms are
a little confusing because most options traded in the UK and the rest of Europe are actually
American options!
■
The premium is the price paid for the option. Option prices are quoted for shares and traded in contracts (or units) each containing 1,000 shares.
■
In the money is where the exercise price for a call option is below the current share price.
In other words, it makes sense to take up the option.
■
Out of the money is where the exercise price for a call option is above the current share
price and it is not profitable to take up the option.
There are two parties to an option contract, the buyer (or option holder) and seller (or
option writer). The buyer has the right, but not the obligation, to exercise the option.
One feature of an option is that, if the share price does not move as expected, it can
become completely worthless, regardless of the solvency of the company to which it
relates. However, if it does move in line with expectations, very considerable gains can
be achieved for very little outlay. Such volatility gives share options a reputation as a
highly speculative investment. But, as will be seen later, options can also be used to
reduce risk.
In return for the option, the purchaser pays a fee or premium. The premium is a
small fraction of the share price, and offers holders the opportunity to gain significant
benefits while limiting their risk to a known amount. The size of the premium depends
on the exercise price and expected volatility of shares, which, in turn, is a function of
the state of the market and the underlying risk of the share. The premium might range
from as little as 3 per cent for a well-known share in a ‘quiet’ market to over 20 per cent
for shares of smaller companies in a more volatile market. During past stock market
collapses, or where there is substantial volatility, option premiums have shot up dramatically to reflect such uncertainty.
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300 Part III Investment risk and return
call option
The right to buy an asset at a
specified price on or before
expiry date
put option
The right to sell an asset at a
specified price on or before
expiry date
exercise date
Final date on which an option
is exercised or expires
A call option gives the purchaser the right to buy a share at a given price within a
set period, usually three months; a put option gives the right to sell. Payment for the
option is not immediate, but takes place when the option is exercised (i.e. taken up) or
on expiry, if it is not exercised. The seller of an option must meet his or her obligation
to buy or sell shares if the right of the purchaser is so exercised. The reward is, of
course, the premium received.
Table 12.1 shows the prices (or premiums) at which options on BP are traded on a
particular day on the traded options market of the Stock Exchange. The options are
traded over a nine-month period with expiry dates every three months. Two exercise
prices are given; the first, at 390p, is below the current share price of 397p (‘in the
money’) and the second, at 420p, is above the current price (‘out of the money’). Notice
that option prices vary both with the agreed exercise price (the lower the exercise price
for a call option, the higher the premium) and the exercise date (the longer the period,
the higher the premium). To buy a call option on BP shares, at an exercise price of 390p,
costs 17p for expiry in April, but 31 12 p for expiry six months later in October.
Self-assessment activity 12.1
By now your head may be spinning with all the terms and concepts introduced. It is therefore a good time to take stock of what you should know.
1
2
3
4
Define a call option and a put option.
What is the basic difference between European and American call options?
Options are available on what types of asset?
In relation to the information on traded options in Table 12.1 explain why the following
features were observed:
(a) the lower the exercise price, the higher the value of a call;
(b) the greater the time to maturity, the higher the price of a call; and
(c) the price paid for calls exceeds the gross profit that could be made by immediately
exercising the call.
(Answer in Appendix A at the back of the book)
■
Speculative use of options: Kate Casino
Kate Casino thinks that oil prices will rise in the coming months and that the share
price will move up sharply from its current level of 397p to a level in April sufficiently above the exercise price of 390p to justify the option price of 17p. Kate
instructs her broker to purchase a contract for 1,000 April call options at a cost of
117p 1,0002 £170. This is termed a naked option, held on its own rather than as a
hedge against loss.
The current share price of 397p is above the 390p exercise price, so the option is
already ‘in the money’, since Kate could immediately exercise her option to buy shares
at 390p to gain 7p, before transaction costs. Of course, she would not do this because
the premium to be paid for the option is 17p.
Table 12.1
Option on BP shares
(current price 397p)
Call option prices (p)
Exercise price
390
420
Put option prices (p)
April
July
Oct
April
July
Oct
17
4 12
24 2
12
31 2
27 12
6 2
24 12
12
28
17
33
1
1
1
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Chapter 12 Identifying and valuing options
301
Let us look at three possible share prices arising in April when the option ends:
Best – if the takeover attempt is made, BP’s share price will rise to 460p by April.
Likely – it will do no better than 415p.
Worst – it falls as low as 380p.
Her profit in each case would be:
Kate Casino’s profit on the call option (pence)
Share price in April
Exercise price
Profit on exercise
Option premium paid
Profit (loss) before transaction costs
Profit on contract of 1,000 shares
Best
Likely
Worst
460
390
70
(17)
53
£530
415
390
25
(17)
8
£80
380
390
Not exercised
(17)
(17)
(£170)
Kate would obviously not exercise her option if the price fell to 380p, so the loss in
this case would be restricted to the 17p premium paid. The premium is the maximum
loss on the contract. If BP’s price on expiry is 415p, the contract profit is a modest £80.
But if the share price shoots up to 460p, a large gain of £530 is made on the contract.
It is interesting to compare the option returns with those from investing directly in
BP shares. Table 12.2 shows that buying a call option has very different effects from
buying the underlying share:
1 The capital outlay for the option contract for 1000 shares is much smaller (£170 compared with £3,970 for the underlying shares).
2 The downside risk on the option contract is far greater in relative terms, but not in
absolute terms. Kate Casino loses all her initial investment on the option contract
while the share value declines by only 4 per cent. However, in money terms, the loss
is the same for both, £170. Of course, the shareholder does not have to sell at the
option expiry date.
3 The return achieved, if the shares reach 460p, is a phenomenal 312 per cent on the
options contract compared with 16 per cent on the underlying shares (ignoring
dividends).
Figure 12.2 shows that, if the share price does not rise above the exercise price of
390p, the option is worthless. The option breaks even at 407p 1390p 17p premium2
and the potential profit to be made thereafter is unlimited.
Table 12.2
Returns on BP shares
and options
Expiry share price
460p
380p
Buy 1,000 shares
Cost 397p each
Proceeds from sale
Profit (loss)
Return over 3 months on original cost
£
(3,970)
4,600
630
15.9%
£
(3,970)
3,800
(170)
4.3%
Call option on 1,000 shares
Cost of option
Cost of exercise at 390p
£
(170)
(3,900)
(4,070)
4,600
530
312%
£
(170)
–
Proceeds on sale
Profit (loss)
Return over 3 months
–
(170)
100%
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302 Part III Investment risk and return
Exercise
price 390p
Profit of 53p
when share
price is 460p
53p
Po
te
nt
ia
lp
ro
fit
Break-even
price 407p
380 390 400 410 420 430 440 450 460
Share price (p)
17p
Figure 12.2
Loss
BP call option
In general, the value of a call option at expiry 1C1 2 with a share price 1S1 2 and exercise price (E) is:
C1 S1 E, if S1 7 E
At a share price of 460p, therefore, the option value is
C1 460p 390p
70p, giving a profit of 53p per share after paying the premium.
■
Options as a hedge: Rick Aversion
While options offer an excellent opportunity to speculate, they are equally useful as a
means of risk reduction, insurance or hedging. Rick Aversion is concerned that the current share price on his BP shareholding will fall over the next two months. Because he
wants to keep his shares as a long-term investment, he buys a put option (see Table 12.1),
giving the right to sell shares in April at the strike price of 390p. This option costs
him 6 12 p.
By late April, the shares have fallen to 350p, and the option has increased in value
to 40p (i.e. 390 350). So Rick sells the option and retains the shares, using the profit
on the option to offset the loss on the shares. This is administratively cheaper and more
convenient than selling his shares and then buying them back. In this way, investors
can capture any profits from a rise in share price and hedge against any price fall.
Figure 12.3 shows that when share prices are above the exercise price, the option
value of the put is worthless. It should be exercised when prices fall below the 390p
exercise price and breaks even at 383 12 p (exercise price less premium).
In general, the value of a put option 1P1 2 is:
P1 E S1, if S1 6 E
At a 370p share price, the value of the put option is therefore 20p:
P1 390p 370p
20p
This is because the holder could buy the shares in the market at 370p and exercise
the option to sell at 390p. The profit on this transaction is 120p 6 12 p2 13 12 p.
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Chapter 12 Identifying and valuing options
303
Gain
3831 2 p
Exercise
price
350 360 370 380 390 400
Figure 12.3
Loss
Share price (p)
61 2 p premium
Break-even price
383 1 2
BP put option
■
Option strategies
Combinations of investments in options and the underlying shares are both of practical and analytical interest. From a practical standpoint a combination can provide a
means of reducing exposure to the risks associated with substantial changes in the price
of the underlying asset, or, from a speculative perspective, can provide some interesting payoff patterns. The analytical interest stems from the insights provided by such
portfolios for the valuation of options.
Straddles or doubles
Combining investments in a put and a call, written on a share at the same exercise
price and expiry date, produces what is referred to as a straddle (long straddle is
where you buy both the call and put option and the opposite is true: a short straddle
is where you sell both the call and put option). Why should anyone wish to invest in
calls and puts simultaneously (short straddle)? This strategy will be employed by an
investor who believes that the price of the underlying share is going to change quite
significantly, but is unable to predict the direction of the change. Such an expectation
will arise, for example, whenever an investor knows that a company is expected to
make an important announcement, but has no knowledge of the content of the
announcement.
This is a strategy to adopt whenever there is considerable short-term uncertainty
about the price of a share, and it is anticipated that this uncertainty will be resolved
before the expiry of the options. A straddle will lose an investor money if there is little
change in the share price, but large price changes in either direction will produce gains.
Protective put
A protective put protects investment in the underlying asset by restricting the possible losses on the asset. Suppose an investor holds shares in British Airways. She may
buy put options to help protect the value of her investment. The put options guarantee a minimum value for the shares up to the expiration date of the options. Whatever
happens the shares can be sold at the option exercise price.
For example: buy British Airways shares at 579p
Protect the investment with April out of the money puts
Exercise price 550p Premium cost 33p
No matter how far the share price falls the investor can sell for 550p up to the expiration
date. This is portfolio insurance, and the cost of the insurance is the put premium of 33p.
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304 Part III Investment risk and return
Alternatively, the investor might choose to protect the investment with in the money
puts, e.g. April 600. Obviously this guarantees a higher minimum selling price up to
expiration, but the premium cost is higher.
Covered call
The writing of calls is a risky business. One way of limiting the risk exposure is to buy
the share on which the call is being written. When an investor simultaneously writes a
call and purchases the underlying asset the resulting combination is known as a covered
call. The returns on the written call and the share are negatively correlated as the liability implicit in the written call increases with rises in the value of the share. Covered calls
may appeal to risk-averse investors who are mildly pessimistic about the future price
performance of a share. The fee income from writing calls is attractive and holding the
share implies the risk from an unanticipated rise in the share price is neutralised.
(Covered calls are of no interest to really pessimistic investors. They will not wish to purchase the share even if the writing of calls is attractive, and if they already hold the share
they will consider its sale or the purchase of puts rather than the writing of calls.)
Covered calls are the combination most frequently employed by financial institutions that regularly write calls. Let us recap on the value of the two main forms of
option, the call and put.
Option
Share price at expiry date
Option value at expiry
Call
above exercise price
below exercise price
above exercise price
below exercise price
share price exercise price
zero
zero
exercise price share price
Put
Consider the implications of buying a call option and selling a put option, where
the exercise price is the same for both.
12.3
OPTION PRICING
We can now focus on what determines the value of options. Option prices comprise
two elements: intrinsic value and time-value. Intrinsic value is what the option would
be worth were it about to expire; it reflects the degree to which an option is ‘in the
money’ – in the case of a call option, the extent to which the exercise price is below the
current share price. The time-value element depends on the length of time the option has
to run – the longer the period, the better the chance of making a gain on the contract.
■
Put–call parity
We showed in the previous section how the combination of buying a call option and
selling a put option gave the same payoff as the underlying share price. To find a combination that yields a riskless return, we reverse the options.
When a call and a put are written on the same asset with the same exercise price and
expiry date a relationship, referred to as the put–call parity, can be expected to hold
between their market values.
Put-call parity
Value of share + Value of put - Value of call = Present value of exercise price
S
+
P
C
=
E/(1 + Rf)
It follows from the above that, given four of the five factors, the fifth can be estimated.
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Chapter 12 Identifying and valuing options
305
The net cash flow expected from investing in a put and a share is equivalent to that
to be expected from investing in a call and placing the present value of the sum necessary to exercise the call in a risk-free investment. In both cases the investor will be
left with a sum equivalent to the exercise price if the share price is less than the exercise price, and the value of the share if its price exceeds the exercise price.
Self-assessment activity 12.2
You take out options contracts to sell a call and buy a put, both at the exercise price of
55p, exercisable one year hence. The cost of the put is 7p and the cost of the call is 1p.
The current share price is 44p and the risk-free interest rate is 10 per cent. What is the
present value of the exercise price?
(Answer in Appendix A at the back of the book)
■
Valuing a call
The following notation is employed with respect to valuing call options:
S0 Share price today
S1 Share price at expiry date
E Exercise price on the option
C0 Value of call option today
C1 Value of call option on expiration date
Rf Risk-free interest rate
A number of formal statements can be made about call options:
1 Option prices cannot be negative. If the share price ends up below the exercise price
on the expiration date, the call option is worthless, but no further loss is created
beyond that of the initial premium paid. In mathematical terms:
C1 0
if S1 E
(12.1)
This is the case where an option is ‘out of the money’ on expiry.
2 An option is worth on expiry the difference between the share price and the exercise price.
C1 S1 E if S1 7 E
(12.2)
This is the case where an option is ‘in the money’ on expiry.
Thus far we have found the intrinsic values of the option – what it would be
worth were it about to expire. We have previously noted that options with some
time still to run will generally be worth more than the difference between current
share price and exercise price because the share price may rise further.
3 The maximum value of an option is the share price itself – it could never sell for more
than the underlying share price value.
C0 S0
(12.3)
The minimum value of a call today is equal to or greater than the current share
price less the exercise price:
C0 S0 E if S0 7 E
(12.4)
But the exercise price is payable in the future. It was shown in the previous section that the payoffs from a share are identical to the payoffs from buying a call
option, selling a put option and investing the remainder in a risk-free asset that
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306 Part III Investment risk and return
yields the exercise price on the expiry date. In other words, we need to bring the
exercise price to its present value by discounting at the risk-free rate of interest. This
gives rise to the following revised statement.
4 The minimum value of an option is the difference between the share price and the present
value of the exercise price (or zero if greater).
C0 S0 3 E>11 Rf 2 t 4
(12.5)
The value of a call option can be observed in Figure 12.4. Bradford plc shares are
currently priced at 700p. The diagram shows how the value of an option to buy
Bradford shares at 1,100p moves with the share price. The upper limit to the option
price is the share price itself, and the lower limit is zero for share prices up to
1,100p, and the share price minus exercise price when share price moves above
1,100p. In fact, the actual option prices lie between these two extremes, on the
upward-sloping curve. The curve rises slowly at first, but then accelerates rapidly.
At point A on the curve, at the very start, the option is worthless. If the share
price for Bradford remained well below the exercise price, the option would remain
worthless. At point B, when the share price has rocketed to 1,400p, the option value
approximates the share price minus the present value of the exercise price. At point
C, the share price exactly equals the exercise price. If exercised today, the option
would be worthless. However, there may still be two months for the option to run,
in which time the share price could move up or down. In an efficient market, where
share prices follow a random walk, there is a 50 per cent chance that it will move
higher and an equal probability that it will go lower. If the share price falls, the
option will be worthless, but if it rises, the option will have some value. The value
placed on the option at point C depends largely on the likelihood of substantial
movements in share price. However, we can say that the higher the share price relative
to the exercise price, the safer the option (i.e. more valuable).
5 The value of a call option increases over time and as interest rates rise. Equation (12.4)
shows that the value of an option increases as the present value of the exercise
price falls. This reduction in present value occurs over time and/or with rises in
the interest rate.
6 The more risky the underlying share, the more valuable the option. This is because the
greater the variance of the underlying share price, the greater is the possibility that
prices will exceed the exercise price. But because option values cannot be negative
(i.e. the holder would not exercise the option), the ‘downside’ risk can be ignored.
Figure 12.4
Option and share price
movements for
Bradford plc
350
B
300
Before expiry
100
50
A
0
700
C
Out of the money
800
900
im
rl
we
Exercise
price
Lo
150
pe
200
it
rl
im
it
250
Up
Price of Bradford Option (p)
400
At expiry
In the money
1,000 1,100 1,200 1,300
Share price (p)
1,400
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Chapter 12 Identifying and valuing options
307
To summarise, the value of a call option is influenced by the following:
■
■
■
■
■
■
contingent claim security
Claim on a security whose
value depends on the value of
another asset
The share price. The higher the price of the share, the greater will be the value of an
option written on it.
The exercise price of the option. The lower the exercise price, the greater the value of
the call option.
The time to expiry of the option. As long as investors believe that the share price has a
chance of yielding a profit on the option, the option will have a positive value. So
the longer the time to expiry, the higher the option price.
The risk-free interest rate. As short-term interest rates rise, the value of a call option
also increases.
The volatility in the underlying share returns. The greater the volatility in share price,
the more likely it is that the exercise price will be exceeded and, hence, the option
value will rise.
Dividends. The price of a call option will normally fall with the share price as a share
goes ex-div (i.e. the next dividend is not received by the buyer).
A call option is therefore a contingent claim security that depends on the value and
riskiness of the underlying share on which it is written.
Self-assessment activity 12.3
Explain why option value increases with the volatility of the underlying share price. List
the factors that determine option value.
(Answer in Appendix A at the back of the book)
■
A simplified option-price model
Valuing options is a highly complex business, including a lot of mathematics or, for
most traders, a user-friendly software package. But we can introduce the valuation of
options by using a simple (if somewhat unrealistic) example. We argued earlier that it
is possible to replicate the payoffs from buying a share by purchasing a call option, selling a put option and placing the balance on deposit to earn a risk-free return over the
option period. This provides us with a method for valuing options.
Valuing a call option in Riskitt plc
In April, the share price of Riskitt plc is 100p. A three-month call option on the shares
with a July expiry date has an exercise price of 125p. With the current price well below
the exercise price it is clear that, for the option to have value, the share price must stand
a chance of increasing by at least 25p over the next quarter.
Assume that by the expiry date there is an equal chance that the share price will
have either soared to 200p or plummeted to 50p. There are no other possibilities.
Assume also that you can borrow at 12 per cent a year, or about 3 per cent a quarter.
What would be the payoff for a call option on one share in Riskitt?
Share price
Less exercise price
Payoff
Best
Worst
200p
(125p)
75p
50p
(125p)
–
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308 Part III Investment risk and return
You stand to make 75p if the share price does well, but nothing if it slips below the
exercise price. To work out how much you would be willing to pay for such an option,
we must replicate an investment in call options by a combination of investing in
Riskitt shares and borrowing.
Suppose we buy 200 call options. The payoffs in July will be zero if the share
price is only 50p and £150 (i.e. 200 75p) if the share price is 200p. This is shown
in Table 12.3. Note that the cash flow we are trying to determine is the April premium, represented by the question mark.
To replicate the call option cash flows, you adopt the second strategy in Table 12.3:
namely, buying 100 shares and borrowing sufficient cash to give identical cash flows
in July as the call option strategy. This means borrowing £50. The net cash flows for
the two strategies are now the same in July whatever the share price. But the £50 loan
repayment in July will include three months’ interest at 3 per cent for the quarter. The
initial sum borrowed in April would therefore be the present value of £50, i.e.
£50>1.03 £48.54. Deducting this from the share price paid gives a net figure of
£51.46, which must also be the April cash payment for 200 call options. The price for
one call option is therefore about 26p.
■
Black–Scholes pricing model
The above example took a highly simplified view of uncertainty, using only two possible share price outcomes. Black and Scholes (1973) combined the main determinants of
option values to develop a model of option pricing. Although its mathematics are
daunting, the model does have practical application. Every day, dealers in options use
it in specially programmed calculators to determine option prices.
For those who like a challenge, the complex mathematics of the Black–Scholes pricing model are given in the appendix to this chapter. However, the key message is that
option pricing requires evaluation of five of the variables listed earlier: share price,
exercise price, risk-free rate of interest, time and share price volatility.
Acorn plc shares are currently worth 28p with a standard deviation of 30 per cent.
The risk-free rate of interest is 6 per cent. What is the value of a call option on Acorn
shares expiring in nine months and with an exercise price of 30p?
The fully-worked solution to this problem is given in the appendix to this chapter,
but we can identify here the five input variables:
Share price 1S2 28p
Exercise price 1E2 30p
Risk-free rate 1k2 6 per cent p.a.
Time to expiry 1t2 nine months
Share price volatility 1s2 30 per cent
Application of the Black–Scholes formula to the above data (see Appendix) gives a
value of the call option of 2.6p.
Table 12.3
Valuing a call option in
Riskitt plc
Strategy
Cash flow
in April
£
1 Buy 200 call options
2 Buy 100 shares
Borrow
?
100
48.54
51.46
Payoff in July if
share price is
200p
50p
£
150
200
50
150
Value of call option £51.46>200 calls 25.73p, say 26p
£
–
50
50
–
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Chapter 12 Identifying and valuing options
309
Black–Scholes option pricing formula
Value of call option (C) is:
C SN1d1 2 EN1d2 2e tk
where
d1 ln1S>E2 tk
st1>2
st1>2
2
d2 d1 st1>2
N(d) is the value of the cumulative distribution function for a standardised normal
random variable and e tk is the present value of the exercise price continuously discounted.
A simplified Black–Scholes formula can be used as an approximation for options
less than one year:
C
1
s1t
S
22
This formula emphasises the impact of volatility and time to expiry on the option
price.
Applying the above to the previous example we derive a slightly higher option
price:
C 0.398 0.3 20.75 28 2.9p
Although the model is complex, the valuation equation derived from the model is
quite straightforward to use, and is widely employed in practice. Four of the five variables on which it is based are observable: the only non-observable variable, the volatility or standard deviation of the return on the underlying asset, is generally estimated
from historical data.
The Black–Scholes model is based on the following assumptions:
there are no transactions costs or taxes;
the expected risk free rate of interest is constant for the period of the option life;
the market operates continuously;
share prices change smoothly over time – there are no jumps or discontinuities in
the price series;
(e) the standard deviation of the distribution of returns on the share is known;
(f) the share pays no dividends during the life of the option; and
(g) the option may only be exercised at expiry of the call (i.e. a European-type option).
(a)
(b)
(c)
(d)
The assumptions on which the model is based are clearly quite restrictive. However,
as these assumptions are consistent with mainstream theorising in finance, the model
integrates well into the general body of finance theory. And of more practical importance the model appears to be quite robust: it is feasible to relax many assumptions
and incorporate more ‘real world’ features into the model without changing its overall character.
12.4
APPLICATION OF OPTION THEORY TO CORPORATE FINANCE
Option theory has implications going far beyond the valuation of traded share options.
It offers a powerful tool for understanding various other contractual arrangements in
finance. Here are some examples:
1 Share warrants, giving the holder the option to buy shares directly from the company at a fixed exercise price for a given period of time.
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310 Part III Investment risk and return
2 Convertible loan stock, giving the holder a combination of a straight loan or bond and
a call option. On exercising the option, the holder exchanges the loan for a fixed
number of shares in the company.
3 Loan stock can have a call option attached, giving the company the right to repurchase the stock before maturity.
4 Executive share option schemes are share options issued to company executives as
incentives to pursue shareholder goals.
5 Insurance and loan guarantees are a form of put option. An insurance claim is the
exercise of an option. Government loan guarantees are a form of insurance. The
government, in effect, provides a put option to the holders of risky bonds so that, if
the borrowers default, the bond-holders can exercise their option by seeking reimbursement from the government. Underwriting a share issue is a similar type of
option.
6 Currency and interest rate options are discussed in later chapters as ways of hedging
or speculating on currency or interest rate movements.
7 Underwriting a new issue of shares when underwriters must take up any shares not
subscribed for by investors.
Two further forms of option are equity options and capital investment options, discussed in subsequent sections.
■
Equity as a call option on a company’s assets: Reckless Ltd
Option-like features are found in financially geared companies. Equity is, in effect, a call
option on the company’s assets.
Reckless Ltd has a single £1 million debenture in issue, which is due for repayment
in one year. The directors, on behalf of the shareholders, can either pay off the loan at
the year end, thereby having no prior claim on the firm’s assets, or default on the
debenture. If they default, the debenture-holders will take charge of the assets or
recover the £1 million owing to them.
In such a situation, the shareholders of Reckless have a call option on the company’s assets with an exercise price of £1 million. They can exercise the option by repaying the loan, or they can allow the option to lapse by defaulting on the loan. Their
choice depends on the value of the company’s assets. If they are worth more than £1
million, the option is ‘in the money’ and the loan should be repaid. If the option is ‘out
of the money’, because the assets are worth less than £1 million, option theory argues
that shareholders would prefer the company to default or enter liquidation. This
option-like feature arises because companies have limited liability status, effectively
protecting shareholders from having to make good any losses.
Derivatives: a double-edged sword
Three years ago, Jackie Brown, a housewife from
Leicestershire who trained as a market researcher,
became a full-time day trader in investment derivatives.
Ms Brown is one of the many private investors who
have been drawn by the flexibility of derivatives, which
allow buyers – usually for a small consideration – to
gain exposure to the performance of an underlying
share, index or security without physically owning it.
Derivatives are the proverbial double-edged sword.
They enable investors to isolate certain risks, such as
interest rate risk or credit risk. Investors can then either
increase risk or hedge it out of their portfolios altogether.
Unlike buying a share or an asset, these instruments
allow investors to go short – sell stock they do not
own – in order to profit on falling markets. The danger
is that investors can lose more than their original stake.
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Chapter 12 Identifying and valuing options
Not surprisingly, derivatives have been vilified in some
quarters and beatified in others. But whatever investors
think about them, these tools are becoming impossible
to ignore and are fast becoming a part of ordinary
investors’ everyday life.
There are many hidden risks in the derivatives market,
warn experts. Warren Buffett, the investment guru who
is famous for his down-to-earth attitude to investing,
memorably billed them ‘weapons of mass destruction’.
His warning reverberated around the market and was
echoed by many others who worry that derivatives markets are opaque and standards of reporting are lax.
12.5
Investors often do not know who the end acquirer of
the risk is and how much accumulated exposure to one
type of risk he might have.
Anyone hoping to delve into spread betting, covered
warrants or options, should take heed. As veteran market watchers always say: Do not buy what you do not
understand, beware of who you are dealing with, and
know that betting with derivatives is seductive but
dangerous.
As Mr Buffett says, it is ‘like hell – easy to enter and
almost impossible to exit’.
Source: Based on Kate Burgess, Financial Times, 25 October 2003.
CAPITAL INVESTMENT OPTIONS
real options
Options to invest in real assets
such as capital projects
■
311
We can now apply option theory to capital budgeting. Capital investment options (sometimes termed real options) are option-like features found in capital budgeting decisions.
While discounted cash flow techniques are very useful tools of analysis, they are generally more suited to financial assets, because they assume that assets are held rather than
managed. The main difference between evaluating financial assets and real assets is that
investors in, say, shares, are generally passive. Unless they have a fair degree of control,
they can only monitor performance and decide whether to hold or sell their shares.
Corporate managers, on the other hand, play a far more active role in achieving the
planned net present value on a capital project. When a project is slipping behind forecast they can take action to try to achieve the original NPV target. In other words, they
can create options – actions to mitigate losses or exploit new opportunities presented
by capital investments. Managerial flexibility to adapt its future actions creates an
asymmetry in the NPV probability distribution that increases the investment project’s
value by improving the upside potential while limiting downside losses.
We will consider three types of option: the abandonment option, the timing option
and strategic investment options.
Abandonment option
option to abandon
Choice to allow an option to
expire. With a capital investment, abandonment should
take place where the value for
which an asset can be sold
exceeds the present value of
its future benefits from continuing its operations
Major investment decisions involve heavy capital commitments and are largely
irreversible: once the initial capital expenditure is incurred, management cannot turn the
clock back and do it differently. The costs associated with divestment are usually very
high. Most capital projects divested early will realise little more than scrap value. In the
case of a nuclear power plant, the decommissioning cost could be phenomenal. Because
management is committing large sums of money in pursuit of higher, but uncertain,
payoffs, the option to abandon, without incurring enormous costs if things look grim,
can be very valuable. Any project that permits management to extract value when things
go bad has an embedded put option. To ignore this is to undervalue the project.
Example: Cardiff Components Ltd
Cardiff Components Ltd is considering building a new plant to produce components for the
nuclear defence industry. Proposal A is to build a custom-designed plant using the latest technology, but applicable only to nuclear defence contracts. A less profitable scheme, Proposal B,
is to build a plant using standard machine tools, giving greater flexibility in application.
Continued
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312 Part III Investment risk and return
The outcome of a general election to be held one year hence has a major impact on the
decision. If the current government is returned to office, its commitment to nuclear
defence is likely to give rise to new orders, making Proposal A the better choice. If the current opposition party is elected, its commitment to run down the nuclear defence industry would make Proposal B the better course of action. Proposal B has, in effect, a put
option attached to it, giving the flexibility to abandon the proposed operation in favour of
some other activity.
Timing option
timing option
The option to invest now or
defer the decision until conditions are more favourable
Figure 12.5
The value of the
options to delay
investments: Cardiff
Components Ltd
The Cardiff Components example not only introduces an abandonment option, it also
raises the timing option. Management may have viewed the investment as a ‘now or
never’ opportunity, arguing that in highly competitive markets there is no scope for
delay. However, most project decisions have three possible outcomes – accept, reject or
defer until economic and other conditions improve. In effect, this amounts to viewing
the decision as a call option that is about to expire on the new plant, the capital investment outlay being the exercise price. If a positive NPV is expected, the option will be
exercised; otherwise the option lapses and no investment is made.
The option to defer the decision by one year, until the outcome of the general election is known, makes obvious sense. This may look something like the curved line in
Figure 12.5.
Value of option to invest
■
Investment
postponed
one year
Now or never
investment
Negative
0
Positive
Project NPV
An immediate investment would yield either a negative NPV – in which case it
would not be taken up – or a positive NPV. Delaying the decision by a year to gain valuable new information (the curved broken line) is a more valuable option. Managements
sometimes delay taking up apparently wealth-creating opportunities because they
believe that the option to wait and gather new information is sufficiently valuable.
Investment as a call option
The five main variables in pricing a share call option can be applied to capital investment (or real) call options.
Share call option
Real call option
Current value of share
Exercise price
Time to expiry
Share price uncertainty
Risk-free interest rate
Present value of expected cash flows
Investment cost
Time until investment opportunity disappears
Project value uncertainty
Risk-free interest rate
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Chapter 12 Identifying and valuing options
■
313
Strategic investment options
follow-on opportunities
Options that arise following a
course of action
Certain investment decisions give rise to follow-on opportunities that are wealth-creating.
New technology investment, involving large-scale research and development, is particularly difficult to evaluate. Managers refer to the high level of intangible benefits
associated with such decisions. What they really mean is that these investments offer
further investment opportunities (e.g. greater flexibility), but that, at this stage, the precise form of such opportunities cannot be quantified.
Example: Strategic options in Harlequin plc
Harlequin plc has developed a new form of mobile phone, using the latest technology. It is
considering whether to enter this market by investing in equipment costing £400,000 to assemble and then market the product in the north of England during the first four years. (Most of
the product parts will be bought in.) The expected net present value from this initial project,
however, is – £25,000. The strategic case for such an investment is that by the end of the project’s life sufficient expertise would have been developed to launch an improved product on a
larger scale to be distributed throughout Europe. The cost of the second project in four years’
time is estimated at £1.32 million. Although there is a reasonable chance of fairly high payoffs,
the expected net present value suggests this project will do little more than break even.
‘Obviously, with the two projects combining to produce a negative NPV, the whole idea
should be scrapped,’ remarked the finance director.
Gary Owen, a recent MBA graduate, was less sure that this was the right course of action.
He reckoned that the second project was a kind of call option, the initial cost being the exercise price and the present value of its future stream of benefits being equivalent to the option’s
underlying share price. The risks for the two projects looked to be in line with the variability
of the company’s share price, which had a standard deviation of 30 per cent a year.
If, by the end of Year 4, the second project did not suggest a positive NPV, the company
could walk away from the decision, the option would lapse and the cost to the company
would be the £25,000 negative NPV on the first project (the option premium). But it could
be a winner, and only ‘upside’ risk is considered with call options.
Gary knew that Harlequin’s discount rate for such projects was 20 per cent and the riskfree interest rate was 10 per cent. Table 12.4 shows his estimation of the main elements to
be considered.
Table 12.4
Harlequin plc: call option valuation
Initial project
Cost of investment
PV of cash inflows
Net present value
Follow-on-project in Year 4
Cost of investment
PV of cash inflows
Net present value in Year 4
Main factors in valuing the call option:
1 Asset value
2 Exercise price
3 Risk-free discount rate
4 Time period
5 Asset volatility
(£000)
(400)
375
(25)
(1320)
1320
–
PV of cash flows at Year 4 discounted to Year 0
£1.32 m>11.22 4
£0.636 m
cost of follow-on project
£1.32 m
10%
4 years
standard deviation of 30%
Continued
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314 Part III Investment risk and return
Gary Owen then entered these variables into a computer model. He found that the present value of the four-year call option to invest in the follow-on project, with an exercise
price of £1.32 million, was worth around £75,000. This is because there is a chance that the
project could be really profitable, but the company will not know whether this is likely until
the outcome of the first project is known. The high degree of risk in the second project actually increases the value of the call option. It seems, therefore, that the initial project launch,
which creates an option value of £75,000 for a ‘premium’ of £25,000 (negative NPV) may
make economic as well as strategic sense.
Such valuation calculations applied to strategic investment options raise as many
questions as they answer. For example, how much of the risk for the follow-on project
is dependent upon the outcome of the initial project? But option pricing does offer
insights into the problem of valuing ‘intangibles’ in capital budgeting, particularly
where they create options not otherwise available to the firm.
12.6
WHY CONVENTIONAL NPV MAY NOT TELL THE WHOLE STORY
Earlier chapters have rehearsed the theoretical argument that capital projects that offer
positive net present values, when discounted at the risk-adjusted discount rate, should
be accepted. In Chapter 7 we raised a number of practical shortcomings with discounted cash flow approaches; here we introduce an important theoretical point.
We have noted that orthodox capital projects analysis adopts a ‘now or never’ mentality. But the timing option reminds us that a ‘wait and see’ approach can add value.
Whenever a company makes an investment decision it also surrenders a call option –
the right to invest in the same asset at some later date. Such waiting may be passive,
waiting for the right economic and market conditions, or active, where management
seeks to gather project-related information to reduce uncertainty (further product trials, competitor reaction, etc.). Hence, the true NPV of a project being undertaken today
should include the values of various options associated with the decision:
NPV of
NPV of
NPV of
NPV of
True NPV basic abandonment follow-on option
project
option
projects
to wait
If the total is positive, the project creates wealth. This is why firms frequently defer
apparently wealth-creating projects or accept apparently uneconomic projects. Senior
managers recognise that investment ideas often have wider strategic implications, are
irreversible and improve with age.
Real options are particularly important in investment decisions when the conventional NPV analysis suggests that the project is ‘marginal’, uncertainty is high and
there is value in retaining flexibility. In such cases, the conventional NPV will almost
always understate the true value.
MINI CASE
Eurotunnel considers all its options
The idea of a road tunnel under the Channel is a legacy
of Baroness Thatcher’s 11-year reign as the prime minister
who got the first tunnel built.
So keen was she on the idea, she insisted Eurotunnel be
contractually obliged to submit a feasibility study by
2000, or lose an exclusive option over the second link.
Continued
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Chapter 12 Identifying and valuing options
Eurotunnel asked two consultants to investigate seven
options for a second link – over and under the water. The
study settled on two options: a two-tier road tunnel or a
second rail tunnel.
Both would probably run alongside the existing
Chunnel; the main difference being that technological
advances would make it possible to build a large singlebore tunnel, rather than the existing two main tunnels
sandwiching a third service tunnel.
The rail option – to be reserved exclusively for
Eurostars and freight trains – sounds safe. For an estimated £3 billion Eurotunnel could simply extend services it
and customers already know.
315
But the report suggests the road tunnel would be more
financially viable. Initial studies suggest that a rail option
would not make an adequate return unless there was a
very significant shift from road to rail.
Whether there will be the passenger demand for a second tunnel of either type is too early to say. Eurotunnel
estimates the existing tunnel will reach capacity use in
2025 – but great changes could happen to travel needs
and methods over a quarter of a century.
The company has ten years to make up its mind – the
deadline is 2010 and it seems in no hurry to be rushed.
Source: Based on Juliette Jowit, Financial Times, 6 January 2000.
Self-assessment activity 12.4
What is the type of option available to Eurotunnel and what factors would you consider in
assessing its value?
(Answer in Appendix A at the back of the book)
SUMMARY
The options literature has developed highly complex models for valuing options, but
insufficient attention has been paid to value creation through options.
Options or option-like features permeate virtually every area of financial management. A better understanding of options and the development of option pricing have
made the topic an increasingly important part of financial theory. We have sought to
increase your awareness of what options are, where they are to be found, and how
managers can begin to value them. The topic is still in its infancy, but its study will
yield important insights into financial and investment decisions.
Key points
■
Option features are to be found in most areas of finance (e.g. convertibles and warrants, insurance, currency and interest rate management, and capital budgeting).
■
Pure options are financial instruments created by exchanges (e.g. stock markets)
rather than companies.
■
The two main types of option are (1) call options, giving the holder the right to buy
a share (or other asset) at the exercise price at some future time, and (2) put options,
giving the holder the right to sell shares at a given price at some future time.
■
The minimum value of a call option is the difference between the share price and
the present value of the exercise price.
■
The value of call options increases as:
– The underlying share price increases.
– The exercise price falls.
– The time to expiry lengthens.
Continued
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316 Part III Investment risk and return
– The risk-free interest rate rises.
– The volatility of the underlying share price increases.
■
The Black–Scholes Option Pricing Model can be applied to estimate the value of call
options.
■
Capital investment decisions may have options attached covering the option to
(1) abandon, (2) delay or (3) invest in follow-on opportunities.
■
Where the value of a company’s assets falls below the value of its borrowings,
shareholders may not exercise their option to repay the loan, but prefer the company to default on the debt.
Further reading
A more detailed treatment of options is found in Brealey, Myers and Allen (2005) and Bodie and
Merton (2000). An introduction to options is given by Redhead (1990). Kester (1984) discusses
the topic of real options and Dixit and Pindyck (1995) provide an easy-to-read article on the
options approach to capital investment. Brennan and Trigeorgis (2000) offer a number of useful
papers on real options. Those who like a mathematical challenge may want to try Black and
Scholes’ (1973) classic paper or Cox et al. (1979). Merton (1998) gives an excellent review of the
application of option pricing, particularly to investment decisions.
Useful websites
Futures and Options World: www.fow.com
Euronext.liffe: www.liffe.com
International Swaps and Derivatives Association: www.isda.org
APPENDIX
BLACK-SCHOLES OPTION PRICING FORMULA
The Black–Scholes formula, for valuing a call option (C), with no adjustment for dividends, is given by:
C SN1d1 2 EN1d2 2e tk
where:
d1 ln1S>E2 tk
1>2
st
d2 d1 st1>2
st1>2
2
We already have described S as the underlying share price and E as the exercise
price. In addition, s is the standard deviation of the underlying asset, t is the time, in
years, until the option expires, k is the risk-free rate of interest continuously compounded, N(d) is the value of the cumulative distribution function for a standardised
normal random variable and e tk is the present value of the exercise price continuously
discounted.
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Chapter 12 Identifying and valuing options
■
317
Example
Acorn plc shares are currently worth 28p each with a standard deviation of 30 per cent.
The risk-free interest rate is 6 per cent, continuously compounded. Compute the value
of a call option on Acorn shares expiring in nine months and with an exercise price of
30p.
We can list the values for each parameter: S 28, s 0.30, E 30, K 0.06,
t 0.75.
st1>2 10.32 10.752 1>2 0.2598
d1 ln1S>E2 tk
1>2
st
st1>2
2
ln128>302 0.75 10.062
0.2598
0.2598
2
0.2655 0.1732 0.1299
0.0375, say 0.04
d2 d1 sr1>2 0.0375 0.2598
002223, say 0.22
Using cumulative distribution function tables:
N1d1 2 N10.042 0.5160
N1d2 2 N10.222 0.4129
Inserting the above into the original equation:
C SN1d1 2 EN1d2 2e tk
2810.51602 3010.41292e 0.045
2.6p
The value of the call is 2.6p.
Strictly speaking, adjustment for dividends on shares should be made by applying
the Merton formula, not dealt with in this text.
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318 Part III Investment risk and return
QUESTIONS
Questions with a coloured number have solutions in Appendix B on page 703.
1 Give two examples where companies can issue call options (or something similar).
2 On 1 March the ordinary shares of Gaymore plc stood at 469p. The traded options market in the shares quotes
April 500p puts at 47p. If the share price falls to 450p, how much, if any, profit would an investor make? What
will the option be worth if the share price moves up to 510p?
3 What is the difference between traditional and exchange traded options?
4 Explain the factors influencing the price of a traded option and whether volatility of a company’s share
option price is necessarily a sign of financial weakness.
5 Frank purchased a call option on 100 shares in Marmaduke plc six months ago at 10p per share. The share
price at the time was 110p and the exercise price was 120p. Just prior to expiry the share price has risen
to 135p.
Required
(a) State whether the option should be exercised.
(b) Calculate the profit or loss on the option.
(c) Would Frank have done better by investing the same amount of cash six months ago in a bank offering
10 per cent p.a.?
6 Find the value of the call option given that the present value of the exercise price is 10p, the value of the put
option is 15p and the current value of the share on which the option is based is 25p.
7 Find the present value of the exercise price given that the value of the call is 19p, the value of the put is 5p
and the current market price of the underlying share is 30p.
8 The current price of a share is 38p and a call option written on this share with six months to run to maturity
has an exercise price of 40p. If the risk-free rate of interest is 10 per cent per annum and the volatility of the
returns on the share is 20 per cent, use the Black and Scholes model to estimate the value of the call.
9 The current price on British Sky Broadcasting is 420.5p and the price of a call option with a strike price of
420p with six months to maturity is 50.5p. The value of a put option with the same strike price and time to
maturity is 38.5p. Determine the annualised rate of interest if put–call parity holds.
10 The following are the closing prices of options on the shares of BAT on Wednesday 10 March 2004.
Calls
Exercise Price
BAT
(*825)
800
850
Puts
Apr
Jun
Sep
Apr
June
Sep
36.5
11.0
53.5
25.5
62.5
35.0
9.0
33.0
20.0
42.0
31.5
55.5
*Current price
Refer to the table as required when answering this question.
(a) Explain the fundamental reasons for the large difference between the price of a September 800 call and
an April 800 put.
(b) Outline a strategy that combines short calls and short puts. Why would an investor adopt such a strategy?
Use data from the table to illustrate some possible payoffs.
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Chapter 12 Identifying and valuing options
11 Spot the options in Enigma Drugs plc. The mini-case presented below incorporates five options. Can you identify the type of option, its length and exercise price? Recall that American options offer the holder the right
to exercise at any time up to a certain date, while a European option is exercised on one particular date.
Enigma Drugs plc is an innovative pharmaceutical company. The management team is considering setting up a separate limited company to develop and produce a new drug.
The project is forecast to incur development costs and new plant expenditure totalling £50 million and
to break even over the next five years (by which time its competitors are likely to have found a way round
the patent rights). Enigma’s management is considering deferring the whole decision by two years, when
the outcome of a major court case with important implications for the drug’s success will be known.
The risks on the venture are high, but should the project prove unsuccessful and have to be abandoned,
the ‘know-how’ developed from the project can be used inside the group or sold to its competitors for a
considerable sum. Enigma’s management realises that there is little or no money to be made in the initial
five years, but it should allow them to gain vital expertise for the development of a ‘wonder drug’ costing
£120 million, which could be launched in four years’ time.
The newly-formed company would be largely funded by borrowing £40 million in the first instance,
repayable in total after eight years, unless the company prefers to be ‘wound up’ for defaulting on the loan.
Some of the debt raised will be by 9 per cent Convertible Loan Stock, giving holders the right to convert
to equity at any time over the next four years at 360p compared with the current price of 297p.
Practical assignment
1 Choose two forms of financial contracting arrangement with option features and show how option pricing theory
can help in analysing them.
2 Consider a major capital investment recently undertaken or under review. Does it offer an option? Could an
option feature be introduced? What would the rough value of the option be?
319
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Part
IV
SHORT-TERM FINANCING AND POLICIES
The acquisition of every asset has to be financed. Companies obtain two forms of finance, short and
long term, although, in practice, it is difficult to make a rigid demarcation between them. Part IV is
devoted to analysing short-term financing, while the analysis of long-term financing decisions
appears in Part V.
Chapter 13 offers an overview of the financing operations of the modern corporation, focusing on
balancing the inflows and outflows of funds in the process of treasury management. The chapter
examines the importance of working capital management, and how the financial manager may use
the derivatives markets.
Chapter 14 looks at managing short-term assets – cash, stocks, debtors – and the financing
implications of different working capital policies. Chapter 15 describes the various forms of short(and medium-) term sources of finance, especially trade credit and the banking system, and also
discusses the analysis of leasing decisions and the finance of foreign trade.
Chapter 13 Treasury management and working capital policy
Chapter 14 Short-term asset management
Chapter 15 Short- and medium-term finance
353
379
321
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13
Treasury Management and working
capital policy
Treasury Management at DS Smith plc
The Group treasury strategy is controlled through a
Treasury Committee, which meets regularly and
includes the Chairman, the Group Chief Executive
and the Group Finance Director. The Group Treasury
function operates in accordance with documented
policies and procedures approved by the Board and
controlled by the Group Treasurer. The function
arranges funding for the Group, provides a service to
operations and implements strategies for interest rate
and foreign exchange exposure management.
The major treasury risks to which the Group is
exposed relate to movements in interest rates and
currencies. The overall objective of the Treasury
function is to control these exposures whilst striking
an appropriate balance between minimising risks
and costs. Financial instruments and derivatives may
be used in implementing hedging strategies, but no
speculative use of derivatives or other instruments
is permitted.
The Treasury Committee regularly reviews the Group’s
exposure to interest rates and considers whether to
borrow on fixed or floating terms. For the last few
years the Group has generally chosen to borrow on
floating rates, which the Committee believes have
provided better value. During the year, however, the
Group took advantage of the historically low level of
medium to long-term sterling interest rates and fixed
the interest rate on £40 million of sterling denominated borrowings for a period of five years at an
average rate (before margin) of just under 4%.
Group policy is to hedge the net assets of major
overseas subsidiaries by means of borrowings in the
same currency to a level determined by the Treasury
Committee. The borrowings in currency give rise to
exchange differences on translation into sterling,
which are taken to reserves. A portion of the Group’s
net borrowings are denominated in euros, which are
held to hedge the underlying assets of our eurozone
operations. At the year end, these borrowings represented 64% of our eurozone net assets.
Reprinted with permission, DS Smith plc, Annual Report and Accounts,
2004.
Learning objectives
Treasury management and working capital policy are central to the whole of corporate finance.
After reading this chapter, you should appreciate the following:
■
The purpose and structure of the treasury function.
■
Treasury funding issues.
■
How to manage banking relationships.
■
Risk management, hedging and the use of derivatives.
■
Working capital policies.
■
The cash operating cycle and overtrading problems.
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324 Part IV Short-term financing and policies
13.1
INTRODUCTION
The introductory case study gives a flavour of the work of the Treasury in a large modern organisation (DS Smith is a leading packaging manufacturer). It also identifies
some of the areas where things can potentially go wrong.
Treasury management, once viewed as a peripheral activity conducted by backoffice boffins, today plays a vital role in corporate management. Most business decisions have implications for cash flow and risk, both of which are of direct relevance to
treasury management. Many major firms have experienced problems through poor
treasury management in recent years. This area has become a major concern in business, particularly the manner in which companies manage exposure to currency and
other risks.
Most companies do not have a corporate treasurer; such a person is usually warranted only in larger companies. However, all firms are involved in treasury management to some degree. Treasury management can be defined in many ways. We will
adopt the Association of Corporate Treasurers definition: ‘the efficient management of
liquidity and financial risk in the business’.
This chapter seeks to explain the main functions of treasury management and to
provide an overview of working capital management. It also acts as an introduction to
many of the succeeding chapters in this book.
13.2
THE TREASURY FUNCTION
The size, structure and responsibilities of the treasury function will vary greatly among
organisations. Key factors will be corporate size, listing status, degree of international
business and attitude to risk. For example, BP plc is a major multinational company
with a strong emphasis on value creation, where currency and oil price movements can
have a dramatic impact on corporate earnings. It is not surprising that it has a highly
developed group treasury function, covering the following:
1 Global dealing – foreign exchange, interest rate management, short-term borrowing,
short-term deposits.
2 Treasury services – cash management systems, transactional banking.
3 Corporate finance – capital markets, banking relationships, trade finance, risk management, liability management.
4 M&A equity management – mergers and acquisitions, equity markets, investor relations and divestitures (from The Treasurer, February 1992).
funding
Cash and liquidity management, short-term financing
and cash forecasting
treasury operations
Financial risk management,
and portfolio management
In most companies, the treasury department is much simpler, typically with a distinction between funding (cash and liquidity management, short-term financing and
cash forecasting) and treasury operations (financial risk management and portfolio
management). Treasury departments have come under increasing scrutiny by the
financial press. Barely a month passes without some large company announcing hefty
losses resulting from some major blunder by its treasury department. In the highly
complex, highly volatile world of finance, there are bound to be mistakes; the secret is
to set up the treasury function such that mistakes are never catastrophic.
It is the responsibility of the board of directors to set the treasury aims, policies,
authorisation levels, risk position and structure. It should establish, for example, the
following:
■
■
■
■
The degree of treasury centralisation.
Whether it should be a profit centre or cost centre.
The extent to which the company should be exposed to financial risk.
The level of liquidity desired.
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Chapter 13 Treasury Management and working capital policy
325
UK TREASURER
International Consumer Products Group
West London
■
■
■
■
■
■
UK headquartered consumer products group with wide range of household name
brands. Turnover exceeds £3 billion from some 40 countries.
Will be a member of a small team reporting to the Group Treasurer and will have
responsibility for all banking, supported by a team of two.
Principal activities will cover the dealing area; cash management systems and liaison
with the Group’s bankers; interest risk management, both forex and interest rate; and
ad hoc projects including overseas banking reviews
Graduate, part or fully qualified ACT with hands-on dealing room experience.
Background is likely to be within a substantial international group. An accountancy
qualification would be advantageous.
Excellent communicator, able to quickly establish credibility and develop sound working relationships across the business. A team-worker with flexibility of approach, committed to technical excellence.
This is a first-class opportunity within a group which has an excellent reputation for its
pro-active approach to treasury management.
A typical job advertisement in the press.
We pick up the last two points later, but deal with the structural issues in the following sections.
■
Degree of centralisation
Even in the most highly decentralised companies, it is common to find a centralised
treasury function. The advantages of centralisation are self-evident:
1 The treasurer sees the total picture for cash, borrowings and currencies and is therefore able to influence and control financial movements on a global basis to achieve
maximum after-tax benefit. The gains from centralised cash management can be
considerable.
2 Centralisation helps the company develop greater expertise and more rapid knowledge transfer.
3 It permits the treasurer to capture any benefits of scale. Dealing with financial and
currency markets on a group basis not only saves unnecessary duplication of effort,
but should also reduce the cost of funds.
The major benefits from decentralising certain treasury activities are:
■
■
■
By delegating financial activities to the same degree as other business activities, the
business unit becomes responsible for all operations. Divisional managers in centralised treasury organisations are understandably annoyed at being assessed on
profit after financing costs, over which they have little direct control.
It encourages management to take advantage of local financing opportunities of which
group treasury may not be aware and be more receptive to the needs of each division.
Profit centres and cost centres
In many large multinational firms, there is a substantial flow of cash each year in both
domestic and foreign currencies. The volumes involved offer the opportunity to speculate,
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326 Part IV Short-term financing and policies
especially if the more favourable interest rates and exchange rates are available. Moreover,
such firms probably employ staff skilled in cash and foreign exchange management techniques and may decide to use these resources pro-actively, i.e. to make a profit.
profit centre treasury
In a profit centre Treasury (PCT), staff are authorised to take speculative positions,
(PCT)
usually within clearly specified limits, by trading financial instruments in the same way
A corporate treasury that aims
as a bank. Such ‘in-house banks’ are judged on their return on capital achieved, although
to makes a profit from its
dealing – managers are judged it is difficult to arrive at an accurate measure of capital employed. The main problem
on profit performance
with operating a profit centre is that traders may exceed their permitted positions, either
through negligence or in pursuit of personal gain. (See the Barings case on page 333.)
Conversely, a cost centre Treasury (CCT) aims at operating as efficiently as possible,
cost centre treasury (CCT)
A treasury that aims to minand eliminates risks as soon as they arise. DS Smith, the firm in the introductory case,
imise the cost of its dealings
clearly operates a CCT, i.e. it hedges rather than speculates, as a matter of policy.
JP Morgan Fleming conducts an annual survey of cash and treasury management
practices, in conjunction with the ACT. In 2003, it found that 82 per cent of its 347
respondents considered their treasury function to be a cost centre (aiming ‘to manage
the exposure providing value-added solutions that do not increase the risk of the company’), while 18 per cent considered their Treasury to be a profit centre (aiming ‘to take
active balance sheet risks to enhance returns’).
Self-assessment activity 13.1
How would you define treasury management?
(Answer in Appendix A at the back of the book)
Let us now examine the four pillars of treasury management: funding, banking relationships, risk management, and liquidity and working capital.
13.3
FUNDING
Corporate finance managers must address the funding issues of: (1) how much should
the firm raise this year, and (2) in what form? We devote two later chapters to these
questions, examining long-, medium- and short-term funding. For the present, we simply raise the questions that subsequent chapters will pursue in greater depth.
1 Why do firms prefer internally generated funds? Internally generated funds, defined as
profits after tax plus depreciation, represent easily the major part of corporate funds.
In many ways, it is the most convenient source of finance. One could say it is equivalent to a compulsory share issue, because the alternative is to pay it all back to shareholders and then raise equity capital from them as the need arises. Raising equity
capital, via the back door of profit retention, saves issuing and other costs. But, at the
same time, it avoids the company having to be judged by the capital market as to
whether it is willing to fund its future operations in the form of either equity or loans.
2 How much should companies borrow? There is no easy solution to this question. But it
is a vital question for corporate treasurers. Borrow too much and the business could
go bust; borrow too little and you could be losing out on cheap finance.
The problem is made no easier by the observation that levels of borrowing differ enormously among companies and, indeed, among countries. Levels of borrowing in Italy, Japan, Germany and Sweden are generally higher than in the UK
and the USA. One reason is the difference in the strength of relationship between
lenders and borrowers. Bankers in Germany and Japan, for example, tend to take
a longer-term funding view than UK banks. Japanese banks may even form part
of the same group of companies. For example, the Bank of Tokyo, one of Japan’s
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Chapter 13 Treasury Management and working capital policy
327
leading banks, is part of the Mitsibushi conglomerate (www.mitsibushi.com). We
devote Chapters 18 and 19 to the key question of how much a firm should borrow.
3 What form of debt is appropriate? If the strategic issue is to decide upon the level of
borrowing, the tactical issue is to decide on the appropriate form of debt, or how to
manage the debt portfolio. The two elements comprise the capital structure decisions. The debt mix question considers:
(a)
(b)
(c)
(d)
form – loans, leasing or other forms?
maturity – long-, medium- or short-term?
interest rate – fixed or floating?
currency mix – what currencies should the loans be in?
The first three issues are discussed in Chapters 15 and 16 and currency issues are
dealt with in Chapter 22.
4 How do you finance asset growth? Each firm must assess how much of its planned
investment is to be financed by short-term finance and how much by long-term
finance. This involves a trade-off between risk and return.
Current assets can be classified into:
(a) Permanent current assets – those current assets held to meet the firm’s long-term
requirements. For example, a minimum level of cash and stock is required at
any given time, and a minimum level of debtors will always be outstanding.
(b) Fluctuating current assets – those current assets that change with seasonal or
cyclical variations. For example, most retail stores build up considerable stock
levels prior to the Christmas period and run down to minimum levels following the January sales.
Figure 13.1 illustrates the nature of fixed assets and permanent and fluctuating current assets for a growing business. How should such investment be funded? There are
several approaches to the funding mix problem.
First, there is the matching approach (Figure 13.1), where the maturity structure of
the company’s financing exactly matches the type of asset. Long-term finance is used
to fund fixed assets and permanent current assets, while fluctuating current assets are
funded by short-term borrowings.
A more aggressive and risky approach to financing working capital is seen in Figure
13.2, using a higher proportion of relatively cheaper short-term finance. Such an
approach is more risky because the loan is reviewed by lenders more regularly. For
example, a bank overdraft is repayable on demand. Finally, a relaxed approach would
be a safer but more expensive strategy. Here, most if not all the seasonal variation in
current assets is financed by long-term funding, any surplus cash being invested in
short-term marketable securities or placed in a bank deposit.
Capital (£)
Fluctuating
current assets
Permanent current assets
Figure 13.1
Financing working
capital: the matching
approach
Fixed assets
0
Time
Short-term
borrowing
Long-term
borrowing +
equity
capital
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328 Part IV Short-term financing and policies
Fluctuating
current assets
Capital (£)
Short-term
borrowing
Figure 13.2
Permanent current assets
Fixed assets
Financing working
capital needs: an
aggressive strategy
0
Long-term
borrowing +
equity
capital
Time
Self-assessment activity 13.2
What do you understand by the matching approach in financing fixed and current assets?
(Answer in Appendix A at the back of the book)
The issue of whether to borrow long-term or short term is examined in more detail
in the next section.
13.4
HOW FIRMS CAN USE THE YIELD CURVE
In Chapter 3, we examined the term structure of interest rates showing the yields on
securities of varying times to maturity. The yield curve offers important information to
treasury managers wanting to borrow funds. Although it is based on the structure of
yields on government stock, similar principles apply to the market for corporate loans,
or bonds. However, corporates have higher default risk than governments so that markets require higher yields on corporate bonds.
The market for government stock provides a benchmark that dictates the general shape of the yield curve with the curve for corporate bonds located above this.
Figure 13.3 reproduces Figure 3.3 with an additional yield curve to describe yields
in the market for corporate bonds. The distance between the two lines represents
the premium required by the market to cover the risk of default by corporate borrowers. For top-grade corporate borrowers, with a very high credit rating, the premium will be relatively narrow, whereas firms considered to be more risky will be
subject to higher risk premia. The corporate versus government yield premium
would usually widen with time to maturity as corporate insolvency risk probably
increases with time.
Today’s yield curve incorporates how people expect interest rates to move in the
future. An upward-sloping yield curve reflects investors’ expectations of higher future
interest rates and vice versa. The action points are clear:
■
■
A rising yield curve may be taken to imply that higher future interest rates are
expected. This suggests firms might borrow long-term now, and avoid variable
interest rate borrowing.
A falling yield curve may be taken to imply that lower future interest rates are
expected. This suggests firms might borrow short-term now, and utilise variable
interest rate borrowing.
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Yield
(%)
Default risk
premium
329
Yields on
corporate
bonds
Yields on
government
securities
Figure 13.3
Years to maturity
Yield curves
■
Words of warning
In some circumstances, managers may be deceived by short-term rates. Say, they follow
a policy of borrowing at short-term rates while the yield curve is upward-sloping,
planning to switch to long-term borrowing when short-term rates exceed long-term
rates.
For example, Jordan plc wants to borrow for six years, and the yield curve currently slopes upwards. The yields on five-year and six-year bonds are 5.5 per cent and
5.8 per cent respectively, while the yield on one-year bonds is 5.0 per cent. So, Jordan
goes for one-year bonds, planning to issue a five-year bond a year later. But what if, a
year later, the whole yield curve shifts upwards due to macro-economic changes, e.g.
a rise in the expected rate of inflation, so that Jordan has to pay say, 7.5 per cent on a
five-year bond? Obviously, this is now more expensive than arranging to lock in the
5.8 per cent rate at the base year. Equally obviously, the reverse could apply – Jordan
may benefit from a downward shift in the yield curve. However, the point is that firms
should not be over-influenced by relatively small differentials along the yield curve.
We examine specific methods of short- and medium-term borrowing in Chapter 15
and methods of long-term borrowing in Chapter 16.
13.5
BANKING RELATIONSHIPS
Many large companies deal with several banks in order to maximise their access to
credit. Global businesses may deal with hundreds of banks; Eurotunnel, at one time,
had 225 banks to deal with! The number of banks dealt with will depend on the company’s size, complexity and geographical spread. While it makes sense to have more
than one bank, too many can make it difficult to foster strong relationships. The real
value of a good banking relationship is discovered when things get tough and when
continued bank support is required.
We often hear the charge, particularly from smaller businesses, that banks are providing an inadequate service or charging too high interest rates. It seems that the banking
relationship can be more of a love/hate relationship than a healthy financial partnership.
A flourishing banking relationship requires the company to deal openly, honestly
and regularly with the bank, keeping it informed of progress and ensuring there are
no nasty surprises.
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330 Part IV Short-term financing and policies
13.6
RISK MANAGEMENT
The financial manager should recognise the many types of risk to be managed:
■
■
■
Liquidity risk – managing corporate liquidity to ensure that funds are in place to
meet future debt obligations. We discuss this later in the chapter.
Credit risk – managing the risks that customers will not pay. We discuss this in the
next chapter.
Market risk – managing the risk of loss arising from adverse movements in market
prices in interest rates, foreign exchange, equity and commodity prices. It is this
form of risk that we now consider.
Every business needs to expose itself to risks in order to seek out profit. But there
are some risks that a company is in business to take, and others that it is not. A major
company, like Ford, is in business to make profits from making cars. But is it also in
business to make money from taking risks on the currency movements associated with
its worldwide distribution of cars?
While the risks of business can never be completely eliminated, they can be managed. Risk management is the process of identifying and evaluating the trade-off
between risk and expected return, and choosing the appropriate course of action.
With the benefit of hindsight, it is all too easy to see that some decisions were
‘wrong’. In this sense, errors of commission are more visible than errors of omission;
the decision to invest in a risky project which subsequently fails is more obvious than
the rejected investment which competitors take up with great success. As with all
aspects of decision making, risk management decisions should be judged in the light
of the available information when the decision is made. The treasurer plays a vital role
in identifying, assessing and managing corporate risk exposure in such a way as to
maximise the value of the firm and ensure its long-term survival.
Self-assesment Activity 13.3
Take a look at the latest Annual Report of Cadbury Shweppes (www.cadburyschweppes.com).
What does the Operating and Financial Review say about its treasury risk management policy?
■
Stages in the risk management process
hedgers
Hedgers tries to minimise or
totally eliminate exposure to
risk
speculators
Speculators deliberately take
positions to increase their
exposure to risk, hoping for
higher returns.
Identify risk exposure. Taking risks is all part of business life, but businesses need to be
quite sure exactly what risks they are taking. For example, while a firm will probably
insure against the risk of fire, it may not consider the risk of loss of profits from the
resulting disruption of the fire. The Brazilian coffee farmer could see his whole crop
wiped out by a late frost. The UK fashion exporter could see her profit margins disappear because of the strong value of sterling.
Before any attempt is made to cover risks, the treasurer should undertake a complete review of corporate risk exposure, including business and financial risks. Some
of these risks will naturally offset each other. For example, exports and imports in the
same currency can be netted off, thereby reducing currency exposure.
Evaluate risks. We saw in Chapter 8, that there are various ways in which the risks
of investments can be forecast and evaluated. The decision as to whether the risk exposure should be reduced will depend on the corporate attitude to risk (i.e. its degree of
risk aversion) and the costs involved. Hedgers take positions to reduce exposure to
risk. Speculators take positions to increase risk exposure.
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Manage risks. The treasurer can manage risk exposure in four ways: risk retention,
avoidance, reduction and transfer, each of which is considered below.
1 Risk retention. Many risks, once identified, can be carried – or absorbed – by the firm.
The larger and more diversified the firm’s activities, the more likely it is to be able
to sustain losses in some areas. There is no need to pay premiums to market institutions when the risk can easily be absorbed by the company. Firms may hold precautionary cash balances, or maintain lower than average borrowing levels, in order
to be better able to absorb unanticipated losses. It should, of course, be borne in
mind that there are costs associated with such action, particularly the lower return
to the firm from holding such large cash balances.
2 Risk avoidance. Some businesses prefer to keep well away from high-risk investments. They prefer to stick to conventional technology rather than promising new
technology manufacture, and to avoid doing business with countries with volatile
exchange rates. Such risk-avoiding behaviour may be acceptable in the short term,
but, ultimately, it threatens the firm’s competitiveness and survival.
3 Risk reduction. We all that know that by having a good diet and taking the right
amount of exercise, we can reduce our exposure to the risk of catching a cold.
Similarly, firms can reduce exposure to failure by doing the right things. Risk of
fire can be reduced by an effective sprinkler system; risk of project failure can be
reduced by careful planning and management of the implementation process and
clear plans for abandonment at minimum cost should the need arise.
4 Risk transfer. Where a risk cannot be avoided or reduced and is too big to be
absorbed by the firm, it can be turned into someone else’s problem or opportunity
by ‘selling’, or transferring, it to a willing buyer. Bear in mind that most risks are
two-sided. There may be a speculator willing to acquire the very risk that the
hedger firm wishes to lose. It is this area of risk transfer which is of particular
importance to corporate finance. Whole markets and industries have developed
over the years to cater for the transfer of risk between parties.
Risk can be transferred in three main ways.
■
■
■
Diversification. We saw, in Chapter 9, that the risk exposure of the firm or shareholder can be considerably reduced by holding a diversified portfolio of investments. Diversification rarely eliminates all risk because most assets have returns
positively correlated with the returns from other assets in the portfolio. It does,
however, eliminate sufficient risk for the firm to consider absorbing the remaining
risk exposure.
Insurance. This seeks to cover downside risk. A premium is paid to the insurer to
transfer losses arising from insured events but to retain any gains. As we saw in
Chapter 12, financial options are a form of insurance whereby losses are transferred
to others while profits are retained.
Hedging. With hedging, the firm exchanges, for an agreed price, a risky asset for a
certain one. It is a means by which the firm’s exposure to specific kinds of risk can
be reduced or ‘covered’. Hence the fashion exporter can now enter into a contract
guaranteeing an exchange rate for her exports to be paid in three months’ time.
Similar hedges can be created for risks in interest rates, commodity prices and many
more transactions.
Hedging has a cost, often in the form of a fee to a financial institution, but this cost
may well be worth paying if hedging reduces financial risks. The extent to which an
exposure is covered is termed the hedge efficiency: eliminating all financial risk is a
‘perfect hedge’ (i.e. 100 per cent efficiency).
Bako Ltd is a medium-size bakery business. The financial manager has identified that
its main risk exposures lie in the following areas:
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332 Part IV Short-term financing and policies
Risk exposure
Market hedge
Raw material prices – specifically, flour and sugar
Currency movements on imports and exports
Interest rate movements on its variable-rate borrowings
Loss of profits, e.g. lost production from a possible
bakery fire or a bad debt
Commodity
Currency
Financial
Insurance
The first three risks can be managed through hedging in the commodity, currency
and financial markets, letting the market bear the risks. The last can be covered
through various forms of insurance.
■
Derivatives
The financial instruments employed to facilitate hedging are termed derivatives,
because the instrument derives its value from securities underlying a particular asset,
such as a currency, share or commodity. One of the earliest derivatives was money
itself, which for centuries derived its value from the gold into which it could be converted. ‘Derivative’ has today become a generic term that is used to include all types of
relatively new financial instruments, such as options and futures.
The esoteric world of derivatives has hardly been out of the news in recent years.
Procter & Gamble, Barings Bank, Metallgesellschaft and Kodak are all examples of
major businesses whose corporate fingers have been burned through derivative transactions. Although sometimes viewed as instruments of the devil, derivatives are really nothing more than an efficient means of transferring risk from those exposed to it,
but who would rather not be (hedgers), to those who are not, but would like to be
(speculators).
Derivatives are financial instruments, such as options or futures, which enable
investors either to reduce risk or speculate. They offer the treasurer a sophisticated
‘tool-box’ to manage risk. A risk management programme should reduce a company’s
exposure to the risks it is not in business to take, while reshaping its exposure to those
risks it does wish to take. Risk exposure comes mainly in unexpected movements in
interest rates, commodity prices and foreign exchange, all of which should be managed.
There are, essentially, four main types of derivative: forwards, futures, swaps and
options.
Forward contracts
A forward contract is an agreement to sell or buy a commodity (including foreign currency) at a fixed price at some time in the future. In business, buyers and sellers are
often subject to exactly opposite risks. The manufacturer of confectionery is concerned
that the price of sugar may rise next year, while the sugar cane producer is concerned
that the price may fall. In a world where it is extremely difficult to predict future commodity prices, both parties may want to exchange uncertain prices for sugar delivered
next year for a fixed price.
By agreeing a price for sugar delivery next year, the confectionery manufacturer
hedges against prices escalating, while the sugar cane producer hedges against prices
dropping. They do this by entering into a forward contract, enabling future transactions and their prices to be agreed today, but not to be paid for until delivery at a specified future date.
Forward markets exist for most of the major commodities (e.g. cocoa, metals and
sugar), but even more important is the forward market in foreign exchange.
A forward currency contract is when a company agrees to buy or sell a specified
amount of foreign currency at an agreed future date and at a rate that is agreed in
advance.
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No future in futures for Barings?
When Nick Leeson was posted by the Barings group to work as a clerk at Simex, the
Singapore International Monetary Exchange, who would have thought that he would eventually, apparently single-handedly, bring the famous bank to its knees?
He progressed well and by 1993 had risen to general manager of Barings Futures
(Singapore), a 25-person operation that ran the bank’s Simex activities. The original role of the
operation was to allow clients to buy and sell futures contracts on Simex, but the group
decided to focus on trading on its own account as part of its group strategy. In the first seven
months of 1994, Leeson’s department generated profits of US$30.7 million, one-fifth of the
whole of Barings’ group profits in the previous year.
The bank set up an integrated Group Treasury and Risk function to try to manage its risk
exposure better. Leeson adopted a new strategy of buying and selling options (or ‘straddles’)
on the Nikkei 225 index, paying the premium into a secret trading account. In effect, he was
betting on the market not having sharp movements up or down. But on 17 January 1995, an
earthquake hit Japan, causing immense damage and loss of life. It also led to a collapse of the
Nikkei 225 index, exposing Barings to huge losses.
Leeson’s response was to invest heavily in buying Nikkei futures contracts in an apparent
attempt to support the market price. Some have suggested he was simply applying the traditional ‘wisdom’ of trying to salvage an otherwise hopeless position by a ‘double-or-quits’
approach. If so, the high-risk strategy backfired. The result is well known: Barings Futures
(Singapore) lost £860 million for the group, leaving the group with no future and resulting
in its acquisition by the Dutch bank Internationale Nederlandes Group (ING) for £1.
Nick Leeson left the following fax for his boss in London: ‘Sincere apologies for the predicament that I have left you in.’
Was it the use of futures derivatives that brought Barings down? Derivatives were certainly
involved, and it is hardly conceivable that such a disaster could have arisen from, say, share
dealing. But it was the strategy and lack of controls – not the instrument – that were the real
problems. To ban derivatives on the grounds that they are dangerous instruments would be
akin to banning cars because they lead to more accidents than bicycles. But we all know that
it is usually the person behind the wheel, not the car, that is at fault. Similarly, it is the derivatives trader and his or her trading strategy that are really the problem when spectacular collapses like that of Barings occur.
For example, if you want to pay US$50,000 in six months’ time, you can use a forward contract to hedge against adverse currency movements. You can agree a price
today that will pay for the dollars by arranging with your bank to buy dollars forward.
At the end of six months, you pay the agreed sum and take delivery of the US dollars
(see Chapter 21 for a fuller explanation).
Futures contracts
Like a forward contract, a futures contract is a commitment to buy or sell an asset at an
agreed date and at an agreed price. The difference is that futures are standardised in
terms of period, size and quality and are traded on an exchange. In the UK, this is the
London International Financial Futures and Options Exchange (LIFFE).
A chemical company plans to buy crude oil in three months’ time. The spot price
(i.e. current market price) for Brent crude is $40 a barrel and a three month futures contract can be agreed at $42 a barrel. To guard against the possibility of an even higher
price rise, the company enters a ‘long’ futures position (i.e. agrees to buy) at $42 a barrel, thereby reducing its exposure to oil price hikes. If, in three months time, the spot
oil price has risen beyond $42, the company will not suffer unforeseen losses.
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334 Part IV Short-term financing and policies
If, however, just before delivery, the spot price has fallen to $38 a barrel, the company will want to benefit from the lower price. It will buy at the spot price and cancel
the long contract by entering into a short contract (i.e. an agreement to sell) at around
the $38 spot price. The loss of $4 a barrel on the two contracts is offset by the profit of
$4 from buying at the spot rather than the original futures price.
Why might a company prefer a futures contract when a forward contract could be
tailor-made to meet its specific requirements? The main reason lies in the obvious benefits from trading through an exchange, not least that the exchange carries the default
risk of the other party failing to abide by the contract terms, so-called ‘counterparty
risk’. For this benefit, both the buyer and seller must pay a deposit to the exchange,
termed the ‘margin’.
Financial futures have become highly popular among both hedgers and traders,
who buy or sell futures in order to profit from a view that the market will go up or
down. The main forms of financial futures contracts cover short-term interest futures,
bond futures and equity-linked futures using stock market indices.
Swaps
Swaps are arrangements between two firms to exchange a series of future payments. A
swap is essentially a long-dated forward contract between two parties through the
intermediation of a third party, such as a bank. For example, a company might agree to
a currency swap, whereby it makes a series of regular payments in yen in return for
receiving a series of payments in US dollars.
Options
An option gives the right, but not the obligation, to buy or sell an asset at an agreed
price at, or up to, an agreed time. It is this right not to exercise the option that distinguishes it from a future. We discussed options in Chapter 12.
A farmer has a ripening crop which he plans to sell in September. He would like to
benefit from any price movements but also be ‘insured’ against any fall in price. A put
option (i.e. the right to sell at an agreed price) is rather like insurance. If the price falls,
the option to sell at an agreed price is exercised. If the price rises, the option is not exercised, and the spot price at the date of sale is taken.
Self-assessment activity 13.4
Consider the following example of a company which plans to buy aluminium. It enters
into a call option contract, paying an appropriate premium for the right to buy aluminium at $1,500/tonne in three months’ time. If, at the end of the period, the spot price is
$1,400/tonne, should the company exercise its option or let it lapse?
(Answer in Appendix A at the back of the book)
■
To hedge or not to hedge
Does hedging enhance shareholder value? Some argue that it helps firms achieve competitive advantage over rivals by cost-effectively reducing risks over which it has little experience and exploiting those risks over which it has strong levels of competence.
Pure theorists, on the other hand, argue that corporate hedging is a costly process
doing no favours for shareholders. After all, portfolio diversification by investors is
one form of hedging. Corporate hedging does nothing that shareholders could not do
themselves, employing derivatives in exactly the same way as corporate treasurers to
follow their own risk management strategy. So why do most large companies hedge?
All shareholders in a business have a vested interest in its long-run prosperity and
hedging risk exposure is an important means of avoiding financial distress.
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In every crisis, there’s risk and opportunity
The Chinese word for crisis (pronounced ‘Wegi’) is made from two words: risk (‘We’) and
opportunity (‘Gi’). Typical managers in the Western world tend to view a crisis as a major problem, but fail to identify the opportunities that such risks bring. However, the economic collapse
in many Far Eastern economies in the late 1990s suggests that they have invested heavily in
commercial opportunities with little regard for the risks. Business survival rests on seizing the
investment opportunity in risky markets, without jeopardising long-run corporate survival.
Korea’s crisis in 1998 was a little matter of virtually the total economy going bust. The IMF
had to step in to provide a $58 billion rescue package and help reschedule $22 billion of foreign debt. Korea had debt-burdened industrial companies, insolvent banks, growing unemployment and high interest rates, plus a massive amount of foreign borrowings. Total corporate
debt was twice the gross domestic product. Now that’s what you call a crisis!
The main reason why so many Korean banks were insolvent was the high level of bad
debts. Insufficient credit assessment was undertaken and major companies, with gearing levels
well beyond anything found in the UK, were encouraged to borrow even more, often investing
their new capital in dubious, high-risk ventures. Getting the balance between risk and opportunity wrong can turn a crisis into economic catastrophe.
Whatever the risk management strategy, it is important that the treasurer explains
to senior management what has been done and what risk exposure remains.
■
Interest rate management
Every company is exposed to a degree of interest rate risk. This occurs when changes
in the interest rate affect a company’s profits and/or the value of its assets and liabilities. The nature of the exposure depends on whether the company is a net borrower or
net investor.
The first form of interest rate risk is basis risk – the risk that the level of interest rates
will change. A second form of risk relates to changes in the yield curve over time. This
was discussed in Chapter 3 and refers to differences in short- and long-term interest
rates. The normal, positive yield curve arises where interest rates increase as the term
lengthens. In practice, however, the curve can be flat or even inverted.
Steps to manage interest rate exposure
The treasurer needs to understand the company’s interest rate risk exposure, how it is
likely to change over time and, where any of these exposures are compensating, how
they can be netted off against each other. The three-step process involves:
1 Identify the expected future cash flows that are exposed to interest rate fluctuations.
2 Specify those rates of interest beyond which steps must be taken to reduce exposure.
3 Reduce exposure by:
– Natural hedging – for example, an exposure to pay a rate of interest on a loan may
be partially offset by an investment linked to the same or a similar rate.
– Fixing the interest rate – loans can be taken out at a fixed rate rather than a floating rate.
– Interest rate swaps. This is an arrangement whereby two parties agree to exchange
interest payments with each other over an agreed period. In other words, Company
A agrees to pay the interest on Company B’s loan, while Company B reciprocates
by paying the interest on Company A’s loan. Of course, what they are really
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336 Part IV Short-term financing and policies
swapping is the different characteristics of the two loans. The most common characteristic being exchanged is the fixed or variable interest rate, and this swap is
termed a plain vanilla or generic swap.
Heavy dependence upon short-term borrowing not only increases the risk of
insolvency from funding long-term assets with short-term borrowing, but also
exposes the company to short-term interest rate increases.
– Hedging contracts. The corporate treasurer has a variety of techniques available
to reduce interest rate risk, many of which have already been discussed. The
main methods are forward rate agreements (FRAs), interest rate futures, interest
rate options, interest rate swaps and more complex methods, such as options on
interest rate swaps (‘swaptions’). We are more concerned with the principles of
interest rate management than the detailed application. The following example
illustrates an approach to managing interest rates.
Managing interest rate risk at MedExpress Ltd
It was Karen Bailey’s first day as the financial controller of MedExpress Ltd, a fastgrowing business in the medical support industry. A quick look at the balance sheet
revealed that the company, although highly profitable, was heavily geared, with large
amounts of debt capital repayment due over the coming years. Interest rates had
changed little over the past two years, but opinions were divided over whether the
Bank of England would have to raise interest rates quite steeply in order to keep inflation within prescribed government limits, or whether rates would hold, or even fall, to
stimulate exports currently suffering from the strength of sterling.
To Bailey’s surprise, the company had taken no steps to manage its exposure to interest rate movements. Her first step was to identify the exposure to interest rate risk.
1 A £2 million overdraft, with a variable interest rate, would have a significant
impact on profits and cash flow if the rate increased in the near future. If the interest rate rise was dramatic, it could seriously affect cash flows and increase the risk
of liquidation.
2 The £5 million fixed-rate long-term loan would become much less attractive if interest rates fell. Paying unduly high interest rates adversely affects profitability.
3 £1.8 million of the fixed rate loan would mature shortly and need replacing. The
company could choose to repay the loan at any time over the next two years. If rates
were expected to rise over that period, early redemption would be preferable.
As Bailey sought to get a grip on the interest rate exposure, she considered the following ways of managing interest rate risk:
(a) Interest rate mix. A mix of fixed and variable rate debt to reduce the effects of
unanticipated rate movements. She would need to give more thought to whether
the existing ratio of £2 million variable/£5 million fixed rate was sufficiently well
balanced.
(b) Forward rate agreement (FRA). Some risk exposure could be eliminated by entering
into a forward rate agreement with the bank. This would lock the company into
borrowing at a future date at an agreed interest rate. Only the difference between
the agreed interest that would be paid at the forward rate and the actual loan interest is transferred.
(c) Interest rate ‘cap’. It is possible to ‘cap’ the interest rate to remove the risk of a rate
rise. If the cap is set at 11 per cent, an upper limit is placed on the rate the company pays for borrowing a specific sum. Unlike the FRA, if the rate falls, the company does not have to compensate the bank.
(d) Interest rate futures. These contracts enable large interest rate exposures to be
hedged using relatively small outlays. They are similar in effect to FRAs, except
that the terms, the amounts and the periods are standardised.
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(e) Interest rate options. Also termed interest rate guarantees, these contracts grant the
buyer the right but not the obligation to deal at a specific interest rate at some
future date.
(f) Interest rate ‘swaps’. These occur where a company (usually very large firms) with
predominantly variable rate debt, worried about a rise in rates, ‘swaps’ or matches its debt with a company with predominantly fixed-rate debt concerned that
rates may fall. A bank usually acts as intermediary in the process, but it can be
through direct negotiations with another company. Each borrower will still remain
responsible for the original loan obligations incurred. Typically, firms continue to
pay the interest on their own loan and then, at the end of the agreed period, a cash
adjustment will be made between the two parties to the swap agreement. Interest
rate swaps can also involve exchanges in different currencies.
Not everyone likes derivatives
Warren Buffet, the so-called ‘Sage of Omaha’, has an excellent track record in managing
his investment vehicle, Berkshire Hathaway, having outperformed the S&P 500 index in 34
of the past 39 years (up to 2003). His success is based largely on sticking to firms that
produce simple basic products for which there is always likely to be a demand. ‘If you
don’t understand it, don’t invest in it’ is one of his mottos – he is famed for not investing
in technology stocks during the internet boom.
He is also very scathing about the relative freedom of companies and dealers to value
positions in swaps, options and other complex products whose prices are not listed on
exchanges, thus giving a potentially misleading picture of a firm’s true future liabilities.
According to Buffet, derivatives are ‘Weapons of Mass Financial Destruction’, time bombs
waiting to explode in the faces of the parties that deal in them, and for the whole economic system. Designed as risk management devices, he says they actually pose risks that central banks and governments have so far found no effective way to control, or even monitor.
Source: Based on Warren Buffet’s annual letter to shareholders, as reported in an article in the Economist, 15 March 2003.
Self-assessment activity 13.5
Define in your own words the main forms of derivatives – forwards, futures, swaps and options.
(Answer in Appendix A at the back of the book)
13.7
WORKING CAPITAL MANAGEMENT
net working capital
Current assets less current
liabilities
The last main area of treasury management is the management of working capital,
including liquidity management. We devote the remainder of this chapter to working
capital policy and the following chapter to short-term asset management. Let us first
clarify the basic terms and ratios employed in working capital management.
Net working capital (or simply working capital) refers to current assets less current
liabilities – hence its alternative name of net current assets. Current assets include
cash, marketable securities, debtors and stock. Current liabilities are obligations that
are expected to be repaid within the year.
Working capital management refers to the financing, investment and control of net
current assets within policy guidelines. The treasurer acts as a steward of corporate
resources and needs to devise and operate clear and effective working capital policies.
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338 Part IV Short-term financing and policies
liquidity management
Planning the acquisition and
utilisation of cash, i.e. cash
flow management
current ratio
Current assets divided by
current liabilities
quick/’acid test’ ratio
Current assets minus stocks,
divided by current liabilities
days cash-on-hand ratio
Cash and marketable securities
divided by daily cash operating
expenses.
Liquidity management is the planned acquisition and utilisation of cash – or near
cash – resources to ensure that the company is in a position to meet its cash obligations
as they fall due. It requires close attention to cash forecasting and planning. If the
wheels of business are oiled by cash flow, the cash forecast, or cash budget, gauges
how much ‘oil’ is left in the can at any time. Any predicted cash shortfall may require
the raising of additional finance, disposal of fixed assets or tighter control over working capital requirements in order to avoid a liquidity crisis.
Various ratios are useful in assessing corporate liquidity, the following being the
most commonly employed:
1 The current ratio is the ratio of current assets to current liabilities. A high ratio (relative to the industry) would suggest that the firm is in a relatively liquid position.
However, if much of the current assets are in the form of raw materials and finished
stocks, this may not be the case.
2 The quick or ‘acid test’ ratio recognises that stocks may take many weeks to realise
in cash terms. Accordingly, it is computed by dividing current liabilities into current
assets excluding stock.
3 Days cash-on-hand ratio is found by dividing the cash and marketable securities by
projected daily cash operating expenses. As its name implies, it indicates the number of days the firm could meet its cash obligations, assuming that no further cash
is received during the period. Daily cash operating expenses should be based on
the projected cash flows from the cash budget, but a somewhat cruder approach is
to divide the annual cost of sales, plus selling, administrative and financing costs,
by 365.
Example: The General Eclectic Company (GEC)
The working capital of GEC is as follows:
£m
Current assets
Stocks and contracts in progress
Debtors
Investments
Cash at bank and in hand
Less creditors due within one year
Net current assets
1,195
1,572
400
1,009
4,176
(2,037)
2,139
Notice that current assets are ranked in descending order of liquidity. The liquidity ratios
for GEC and the industry are:
Current ratio
Acid test
(4,176/2,037)
14,176 1,1952>2,037
GEC
Industry average
2.05
1.46
1.6
1.2
GEC’s current and acid test ratios are both higher than the industry averages, reflecting
the company’s healthy liquidity position. But what would the position look like if the £1 billion of cash were already committed, say, for major capital expenditure? If you recalculate
the current and acid test ratios, you will find that the liquidity position then falls below the
industry average.
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Self-assessment activity 13.6
Which areas of treasury management would you say are most neglected by smaller firms?
(Answer in Appendix A at the back of the book)
13.8
PREDICTING CORPORATE FAILURE
Excessive levels of gearing are often responsible for corporate failure. However, very
highly geared companies do survive and, conversely, some low-geared companies fail.
This suggests that there are many other clues to the viability of a company, and it is not
enough simply to examine a single Balance Sheet ratio when attempting to predict
financial failure.
The Z-score method, developed by Altman (1968), attempts to balance out the relative importance of different financial indicators. This was based on examining the
financial characteristics of two samples of failed and surviving US companies to detect
which ratios were most important in discriminating between the two groups. For
example, were past failures characterised by low liquidity ratios? What other ratios
were important discriminators, and what was their relative importance?
Using a technique called discriminant analysis, the relative significance of each critical ratio can be expressed in an equation that generates a ‘Z-score’, a critical value
below which failed firms typically fall, and above which survivors are located. In general terms, the equation is:
Z a bR1 cR2
In this equation, a, b and c are constants derived from past observations and R1 and
R2 are two identified key discriminatory ratios.
A Z-score model using data for UK firms was developed by Marais (1982), an extension of which is currently used by the Datastream database. For Datastream, Marais
examined over 40 ratios before settling on four critical ones in his final model:
1 Profitability:
2 Liquidity:
3 Gearing:
4 Stock Turnover:
Pre-tax profit depreciation
Current liabilities
Current assets less stocks
Current liabilities
All borrowing
Total capital employed less intangibles
Stock
Sales
Other analysts, using different samples of firms, employ different ratios and weightings in the equation for Z. In Marais’ model, the critical Z-value is zero. This does not
prove that an existing company displaying a Z-score of around zero is on the brink of
insolvency, merely that the firm is displaying characteristics similar to previous failures. Given that there are accounting policy differences between companies, it may be
more useful to look at changes in the Z-score over time. A declining Z-score suggests a
worsening financial condition, while an improving Z-score indicates strong corporate
financial management.
Corporate failure models, such as Z-scores, have their weaknesses (e.g. see Grice
and Ingram, 2001):
(a) ‘Failure’ is difficult to define. Usually its definition is wider than liquidation, but
all sorts of restructuring and rescue operations arise for a variety of reasons.
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340 Part IV Short-term financing and policies
(b) All models are based on the past, when macroeconomic conditions were different
from the present.
(c) Companies employ different accounting policies, making comparison difficult.
Z-scoring is used primarily for credit risk assessment by banks and other financial
institutions, industrial companies and credit insurers. While it does not tell the whole
story behind the company’s prospects, it is widely regarded as an important indicator
of a company’s financial health and hence its credit status.
13.9
CASH OPERATING CYCLE
For a typical manufacturing firm, there are three primary activities affecting working
capital: purchasing materials, manufacturing the product and selling the product.
Because these activities are subject to uncertainty (delivery of materials may come
late, manufacturing problems may arise, sales may become sluggish, etc.), the cash
flows associated with them are also uncertain. If a firm is to maintain liquidity, it
needs to invest funds in working capital, and to ensure that the operating cycle is
properly controlled.
The cash operating cycle is the length of time between the firm’s cash payment for
purchases of material and labour, and cash receipts from the sale of goods. In other
words, it is the length of time the firm has funds tied up in working capital. This is calculated as follows:
Cash operating cycle stock period customer credit period
supplier credit period.
■
The cash operating cycle: Briggs plc
Briggs plc, a manufacturer of novelty toys, has the following working capital items in
its Balance Sheet at the start and end of its financial year:
Stock
Debtors
Creditors
1 January
31 December
£5,500
£3,200
£3,000
£6,500
£4,800
£4,500
Turnover for the year, all on credit, is £50,000 and cost of sales is £30,000. For how many
days is working capital tied up in each item? What is the cash operating cycle period?
Our first task is to calculate the turnover ratios for each:
£30,000
Cost of sales
5 times p.a.
Average stock
£6,000
£50,000
Sales
12.5 times p.a.
Debtors’ turnover Average debtors
£4,000
£30,000
Cost of sales
8 times p.a.
Creditors’ turnover Average creditors
£3,750
Stock turnover To find the number of days each item is held in working capital, we divide the turnover
calculations into 365 days:
Stock period 365>5
73 days
Debtors 1customer credit2 period 365>12.5 29.2 days
Creditors’ 1supplier credit2 period 365>8
45.6 days
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Chapter 13 Treasury Management and working capital policy
Customer
credit
period
(29 days)
Stock conversion
period (73 days)
Supplier credit
period
(46 days)
Figure 13.4
Materials
purchased
341
Cash conversion
cycle
(73 + 29 – 46 = 56 days)
Finished
goods
sold
Cash paid
for
materials
Time
Cash
received
from sales
Cash conversion cycle
The cash operating cycle is therefore:
173 29.2 45.62 56.6 days
This is illustrated in Figure 13.4.
Self-assessment activity 13.7
Explain why two firms in the same industry could have very different cash operating cycles.
What are the financial implications?
(Answer in Appendix A at the back of the book)
Amazon spreads its risks
Has Jeff Bezos just made a big mistake?
Last week, the chairman of Amazon.com told securities
analysts that the company planned to start selling personal computers in the second half of 2001.
By traditional retailing logic, this is a bizarre mistake.
In the past, retailers have more often succeeded by concentrating on a small number of related product lines
than by trying to become generalists.
There is a simple reason for this: to sell something
effectively, you need to know a lot about the product.
Without this knowledge, you risk filling your shelves with
items that customers do not want.
In the early days of electronic commerce, it looked as
though these rules did not apply to online retailing.
Companies such as Amazon kept no inventories of the vast
majority of books they sold: only when your order came in
did they buy in the book you wanted from a wholesaler.
Thanks to the clever use of software, the process
happened so quickly that the book arrived within a few
days – just as fast as from a mail order retailer that was
a little slower off the mark in shipping its orders. And
this way of doing business had a marvellous advantage:
what accountants call a negative operating cycle.
Because the retailer got credit, it could sell the books to
customers and get paid before having to settle up with
its suppliers. Instead of sucking a flow of cash out of the
business, the products being sold provided working capital for other purposes.
As competition intensified, however, the customers
expected more reliable fulfilment. Thus Amazon, along
with everybody else, was forced to keep more items
in stock. That is why the company has ended up as
one of the larger operators of centralised inventory
in the US.
The attractions of the negative operating cycle are still
in place. Amazon can still receive payment for its sales
before paying its suppliers.
Source: Based on article by Tim Jackson, Financial Times, 12 June 2001.
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342 Part IV Short-term financing and policies
13.10
WORKING CAPITAL POLICY
The treasury manager should ensure that the firm operates sound working capital policies. These policies cover such areas as the levels of cash and stock held, and the credit
terms granted to customers and agreed with suppliers. Successful implementation of
these policies influences the company’s expected future returns and associated risk,
which, in turn, influence shareholder value.
Failure to adopt sound working capital policies may jeopardise long-term growth
and even corporate survival. For example:
1 Failure to invest in working capital to expand production and sales may result in
lost orders and profits.
2 Failure to maintain current assets that can quickly be turned into cash can affect
corporate liquidity, damage the firm’s credit rating and increase borrowing costs.
3 Poor control over working capital is a major reason for overtrading problems,
discussed later in this chapter.
Typical questions arising in the working capital management field include the
following:
■
■
■
What should be the firm’s total level of investment in current assets?
What should be the level of investment for each type of current asset?
How should working capital be financed?
We now consider how firms establish and finance the levels of working capital
appropriate for their businesses, and how they impact on profitability and risk. The
level and nature of working capital within any organisation depend on a variety of factors, such as the following:
■
■
■
■
■
■
The industry within which the firm operates.
The type of products sold.
Whether products are manufactured or bought in.
Level of sales.
Stock and credit policies.
The efficiency with which working capital is managed.
We saw in Chapter 1 that the relationship between risk and the required financial
return is central to financial management. Investment in working capital is no exception. In establishing the planned level of working capital investment, management
should assess the level of liquidity risk it is prepared to accept, risk in the sense of the
possibility that the firm will not be able to meet its financial obligations as they fall
due. This is a further dimension of financial risk.
■
Working capital strategies: Helsinki plc
Helsinki plc, a dairy produce distributor, is considering which working capital policy it
should adopt.
Figure 13.5 shows the two working capital strategies under consideration. Notice
that both schedules are curvilinear, suggesting that economies of scale permit working capital to grow more slowly than sales. The firm operates with lower levels of
stock, debtors and cash under a more aggressive approach than under a more relaxed
strategy.
A relaxed, lower risk and more flexible policy for working capital means maintaining a larger cash balance and investment in marketable securities that can quickly be
turned into cash, granting more generous customer credit terms and investing more
heavily in stock. This may attract more custom, but will usually lead to a reduction in
profitability for the business, given the high cost of tying up capital in relatively low
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Chapter 13 Treasury Management and working capital policy
Figure 13.5
343
Relaxed
strategy
40
Aggressive
strategy
30
20
10
0
Helsinki plc working
capital strategies
10
20
40
60
Sales (£)
80
100
e is for ‘efficiency’
In 2000, the big-three US car-makers, General Motors, Ford and DaimlerChrysler, joined forces
to develop a jointly-owned procurement exchange, in turn causing suppliers to worry about
pressures from manufacturers on component prices. In response, six of the largest parts suppliers also combined to examine e-commerce initiatives in an effort to accelerate cost savings. Their aim was to improve supply-chain management and customer support, and
management of after-market activities.
The CEO of one supplier, Eaton, averred: ‘By working together on joint technology solutions, we can avoid repetitive costs and establish common solutions that ultimately improve
effectiveness throughout the supply chain.’
Since 2000, the fears of suppliers that the manufacturers would reap the main benefits of
technology-driven procurement have receded, as the two sides now co-operate in a system
that has evolved from these early developments, namely the Covisint Communicate portal
service, that now serves more than 175,000 users from 20,000 companies. In particular, suppliers to the automobile manufacturers are now able to use this service to procure their own
inputs more economically.
The following mini-case study is taken from Covisint’s website recording Ford’s experience.
Ford
Ford already understood the value of a portal in working collaboratively with suppliers when it
chose to outsource the development and maintenance to Covisint. Covisint Communicate is
used to provide the Ford Supplier Portal which improves sharing of information and collaborative
business processes with suppliers. Covisint has provided these services to enable the Ford Supplier
Portal since 2001. Covisint Communicate helps Ford save on the cost of maintaining a supplierfacing portal and frees valuable resources to direct their attention to improving business processes
with suppliers.
The Covisint Communicate service is used by Ford to securely share a large number of Fordspecific applications with global supplier companies. In addition, Ford is able to maintain an
extensive library of updated documents and information that suppliers need to collaborate with
Ford. Covisint Communicate is available in seven languages and used by Ford and its suppliers
globally.
The website also records the experience of Visteon, a parts supplier that was spun-off from
its parent, Ford, and found that it needed to rapidly develop a supplier portal and supplier
access management system to maintain competitiveness, and how it found the solution at
Covisint.
Source: Based on article by Nikki Tait, Financial Times, 4 June 2000, and Covisint website (www.covisint.com).
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344 Part IV Short-term financing and policies
profit-generating assets. Conversely, an aggressive policy should increase profitability, while increasing the risk of failing to meet the firm’s financial obligations.
In Table 13.1, the relaxed working capital strategy involves a further £20 million
investment in current assets. The additional stocks and more generous credit facili